We all know we should save for retirement, but study after study shows that most Americans aren't saving enough. But putting money in a checking account rather than a 401(k) not only endangers our retirements. It also costs us money. Here's how.
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Before money makes it from your employer's bank account to your paycheck, Uncle Sam takes a bite. However, you can prevent that by contributing money to retirement plan at work or to a deductible traditional IRA (if you're eligible), since your contributions reduce your taxable income dollar for dollar. Put another way, if you're in the 28% tax bracket, every dollar that doesn't go into a retirement account increases your tax bill by 28 cents.
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Capital gains, interest, and dividends on investments in non-retirement accounts get taxed in the year you receive them. Not only does this increase your tax bill year after year, but it leaves less money behind to make more money. However, the money in a 401(k) or IRA grows tax-deferred, which means you don't pay taxes on that money until you make withdrawals in retirement. (If you have a Roth IRA, you won't ever pay taxes on the growth, though you won't get a deduction on the contributions.)
You don't get the employer match
Picture this: Your boss (or the CEO of your intergalactic megalo-conglomerate) is holding out $25 to you -- all you have to do is make sure $100 from your next paycheck goes into the company retirement plan. That's right. If your employer offers a 25% match on retirement contributions, she's essentially offering to pay you to save. For every $100 you don't contribute to the plan, you leave $25 of bonus pay in your boss' pocket (and even more if your company matches 50 cents on the dollar).
Let's tie all this together in one tidy example to see how utilizing retirement accounts can do more for an investor than improve his post-employment prospects. How much could a hypothetical investor save by contributing to a retirement account?
- Income-tax savings realized by contributing $4,000 a year to a 401(k) (assuming 28% tax bracket): $1,120
- Money gained by receiving company match (25%): $1,000
- Income-tax savings from tax-deferred growth (assuming 5% interest on $4,000): $56
Thus, for this fictional fellow, contributing $4,000 to a 401(k) increased his net worth by an additional $2,176. This doesn't even consider a myriad of other variables, such as state income tax savings and more money to compound through the years. Even if someone doesn't receive an employer match, the tax savings are compelling.
So start contributing to your retirement accounts now. You can't afford not to.