Personal Finance in Your 20s and 30s: Valuing Retirement Accounts
Where possible, focus on saving and investing in accounts that offer you tax advantages. Retirement accounts — such as a 401(k), 403(b), SEP-IRA, and so on — offer tax breaks to people of all economic means. In fact, lower-income and moderate-income earners have some additional tax breaks not available to higher-income earners.
Consider the following advantages to investing in retirement accounts:
- Contributions are generally tax-deductible. By putting money in a retirement account, you not only plan wisely for your future but also get an immediate financial reward: lower income taxes. Paying less in income taxes now means more money is available for saving and investing. Retirement account contributions are generally not taxed at either the federal or state income-tax level until withdrawal (but they’re still subject to Social Security and Medicare taxes when earned).
If you’re paying, say, 30 percent between federal and state taxes, a $5,000 contribution to a retirement account immediately lowers your income taxes by $1,500.
- Returns on your investment compound over time without taxation. After you put money into a retirement account, any interest, dividends, and appreciation (investment returns) add to your account without being taxed. Of course, there’s no such thing as a free lunch; these accounts don’t generally allow for complete tax avoidance. (Health savings accounts can offer complete tax avoidance. Also, though it offers no upfront tax breaks, the Roth IRA enables future tax-free withdrawals.) Yet you can get a really great lunch at a discount: You get to defer taxes on all the accumulating gains and profits until you withdraw the money down the road. Thus, more money is working for you over a longer period of time.
- Lower-income earners can get a special tax credit. In addition to the tax breaks I discuss previously, U.S. tax laws also provide a special tax credit, which is a percentage (ranging from 10 to 50 percent) of the first $2,000 contributed (or $4,000 on a joint return) to a retirement account. Unlike a deduction, a tax credit directly reduces your tax bill by the amount of the credit. The credit isn’t available to those under the age of 18, full-time students, or people who are claimed as dependents on someone else’s tax return.
Married couples filing jointly with adjusted gross incomes (AGIs) of less than $62,000 and single taxpayers with an adjusted gross income of less than $31,000 can earn this retirement saver’s tax credit (claimed on Form 8880) for retirement account contributions.
- Matching money may be available. In some company retirement accounts, companies match a portion of your own contributions. Thus, in addition to tax breaks, you get free extra money (terms vary by company) courtesy of your employer. But you have to contribute some of your own money to get the matching money. If you don’t, you’re essentially throwing away money, which is never a good thing to do!