Maximize Your Savings for the Future
In order to support yourself after retiring, you will need a source of income that will stretch further than the safety net of Social Security.
Some employers offer traditional pensions, which pays retirement income based on your final salary and time on the job. Others contribute to a cash balance, profit sharing or other plan on your behalf. But most employers offer you the opportunity to participate in a salary reduction plan, such as a 401(k) or 403(b).
If you participate in your employer’s 401(k) or 403(b) plan, a percentage of your gross income will be withheld each pay period in an account in your name and will accumulate tax-deferred earnings on those contributions. That means the earnings are reinvested to increase the base on which additional earnings can accumulate, a process called compounding.
Participating in a 401(k) or 403(b) plan has three big advantages:
- Any tax-deferred contributions reduce your current income taxes since they are subtracted from your income before tax withholding is calculated.
- Contributions to a tax-free Roth 401(k) or 403(b) aren’t deductible. But when you withdraw after 59½, your earnings are tax free if your account has been open at least five years.
- Many employers match a percentage of the contributions you make.
When compounding is involved, time is money. The more years that you add contributions to your plan and the more years that any earnings increase your principal, the larger your account balance has the potential to grow.
Of course, there are no guarantees about either the rate or the regularity of the earnings. They may be outstanding one year and dismal the next or they alternate between periods of growth and decline. That is the reality of investing. Having time on your side means that bumps in the road, like a period when investment prices go down and your account value shrinks, may be setbacks - but they don’t have to be fatal.
Bright and Early
To show the impact of early investing in a 401(k) or other retirement savings plan, use a savings calculator to compare the potential results if you begin investing at different points in your working life.
For example, assume your employer doesn’t match your contributions and you contribute $5,000 every year, earning 8% interest and will stop contributions at age 65.
- Starting at age 45 - your account value will be approximately $247,000 at age 65, based on total contributions of $100,000.
- Starting at age 35 - your account value will be approximately $611,000 at age 65, based on total contributions of $150,000.
- Starting at age 25 - your account value is almost $1.4 million at age 65, based on total contributions of $200,000.
Remember that returns are not guaranteed. Your return could be low and you could lose as well as make money – that’s why it’s important to start saving early.
A 401(k) by Any Other Name
401(k) plans are the most common and best known, employer sponsored salary reduction plans. But they’re not the only ones. If you work for a not-for-profit organization such as a school or college, a hospital, cultural institution or charitable organization, your employer may offer a 403(b) plan, which operates in much the same way as a 401(k).
Similarly, the plan a state or municipal government offers may be a 457 plan, while federal government departments and agencies provide a thrift savings plan (TSP). And if you work for a small company—one with fewer than 100 employees—you may be part of a SIMPLE plan, an acronym for Savings Incentive Match Plan for Employees.
The rules differ slightly for each type of plan and even among plans of the same type. But all offer the opportunity for tax-deferred earnings.