Saving for retirement should be one of your biggest financial priorities, but it also requires foresight that doesn't come naturally to everyone.
Fortunately, retirement accounts make that sort of long-term thinking easier by providing incentives that reward you for committing to a financial-planning strategy that will span your entire lifetime. Below, you'll learn why smart people take advantage of retirement accounts, and whether they work for you.
Reason 1: Certain retirement accounts offer up-front tax breaks
One of the easiest ways to reduce your taxes is to contribute to a retirement account. Traditional IRA contributions are usually deductible from your taxes in the tax year for which the contribution is made.
Contributions to a 401(k) are excluded from your reported income on your W-2 tax form at the end of the year, thereby also reducing your taxable income. If you take full advantage of both IRAs and 401(k)s, you can set aside well over $20,000 each year toward your retirement based on current contribution limits -- and that's enough to create a sizable nest egg for your golden years.
Reason 2: Certain other retirement accounts give you tax-free growth
All IRAs, 401(k) plans, and other tax-favored retirement accounts offer tax-deferred growth. That means that you don't pay taxes on income from interest, dividends, capital gains, or other sources as long as the money remains within the retirement account. Only on withdrawal do the proceeds from traditional IRAs and 401(k)s get taxed.
Roth IRAs and Roth 401(k)s, on the other hand, have favorable provisions when it comes time to take withdrawals. Roth accounts don't offer upfront tax deductions, but they do allow withdrawals on a tax-free basis, as long as they're made after age 59-1/2, or for certain permitted purposes. Escaping tax entirely on high-growth investments is tough to do, but Roths get the job done.
Reason 3: 401(k) plans can get you extra money
Regardless of what type of retirement account you use, the money that you contribute on your own is always yours to keep. However, the added benefit of 401(k) plans, and similar employer-sponsored retirement plans, is that often, your employer will kick in some extra money, as well.
Employer contributions typically come in two forms. One is the profit-sharing contribution, which often is a percentage of your salary, and is made regardless of how much you contribute yourself. But the more-important feature that some 401(k)s have involves employer matching contributions.
With these plans, employers kick in a certain amount of money toward your retirement, but only if you make contributions, as well. It almost always makes sense to contribute at least enough to get the free money from the employer match, and that can be a powerful tool to encourage retirement savings across the workforce.
Reason 4: Retirement accounts are generally excluded from financial resources for financial-aid purposes
If you're putting a child through college, then for purposes of getting financial aid, you have to report your income and available assets. The school will then take those numbers and calculate the required family contribution, and it will structure a financial-aid plan around any shortfall between the cost of education and the available contribution from the family.
However, financial aid forms don't require you to count retirement money held in qualified retirement accounts like IRAs and 401(k)s in determining the appropriate family contribution. As a result, boosting your retirement contributions will potentially make your child eligible for more financial aid, and that can be worth thousands of dollars toward your child's future.
Reason 5: Retirement accounts impose discipline
Putting money in a retirement account has the psychological benefit of separating it from other savings. Once the money is in the retirement account, it can be difficult to take it out without incurring draconian penalties.
For example, if you haven't yet turned 59-1/2, and take money out of a traditional IRA, you'll not only pay tax on the withdrawn amount, but also pay a 10% penalty on top of that -- unless an exception applies. The prospect of losing your hard-earned retirement money to the IRS can be sufficient to persuade you not to tap IRAs and 401(k) accounts, instead letting them grow until you reach retirement.
Using retirement accounts is a smart way to save for the long run. Given how important it is to maintain financial stability after you retire, the benefits of IRAs, 401(k) plan accounts, and other retirement-savings vehicles are well worth the effort.