Saving for retirement can be likened to going on a diet. What you need to succeed in both cases is a long-term mindset and the discipline to stay the course along the way. Let’s face it, we live in a fast-food culture where we want everything now and we lack the patience to wait more than a minute. Think of it this way, if we cut our calories and start an exercise program, we want to see 10 lbs. gone the next time we step on the scale. Ask yourself this, “can I do all of this work and wait an entire month before I step foot on the scale to see my progress?” Avoiding the daily check-ins might actually prevent dieters from becoming discouraged by the daily roller coaster of results.
When we save and invest our hard-earned dollars, we want to know that our money is safe, and we want to see an immediate rate of return. If we’re not seeing positive returns, what happens? We start to question ourselves, just like when on that diet. “Why am I working so hard and not achieving my goals?” Should it become an affirmation worth repeating daily that this is not a short-term strategy? We must stay the course, maintain our discipline, and exercise patience in order to produce the outcomes we seek.
So now that we’ve established a long-term investment strategy is necessary and you’ve made the commitment to start saving for retirement, what comes next? There are a few points to consider when contemplating retirement that will direct the next steps in your savings plan.
It’s a lot like food selection when on a diet. You will start with determining what type of investment account makes the most sense. For those who have an employer-sponsored savings plan, like a 401k, you should consider contributing an amount that qualifies you for the maximum employer match. If your employer matches up to 3%, you should consider contributing 3% to receive this “free money.”
The 401k plan is a nice option for savings when your individual or household income exceeds the limits for Traditional IRA and ROTH IRA contributions. Any Traditional 401k contributions are tax deferred, meaning your income is taxed after your contribution has been deducted from your pay. This can have a positive impact on your annual taxes. If your 401k plan offers a ROTH option, you will contribute with after-tax dollars but the growth is tax-free, meaning any future withdrawals are not subject to tax.
If you do not have a 401k plan, you could consider a Traditional or ROTH IRA. There are income and contribution limits to consider with these investment accounts, along with different tax treatments for each IRA. The Traditional IRA will offer you tax deductible contributions and the ROTH IRA offers you tax-free growth. There are several other employer-sponsored retirement plans for small business owners that benefit the owner and the employees, such as a SEP IRA and a SIMPLE IRA. You can visit the following IRS website link to learn more about the variations.
The one element these retirement plans have in common is the age at which you can begin withdrawing your retirement savings, and that is age 59-1/2. If you decide to withdraw funds sooner, you will be subject to a 10% IRS penalty. Additionally, every withdrawal from a 401k or Traditional IRA generates taxable income that is taxed at your marginal tax rate. This could be 25% or higher. If you’re planning to work beyond age 59-1/2 then you should not be as concerned about funding your lifestyle in retirement with what you’ve saved in these accounts.
However, what if retirement comes before age 59-1/2 and you need savings to support your early retirement lifestyle? This is where so many fall short in planning because the focus tends to be exclusively on retirement savings for tax deferrals, tax deductions, and tax-free growth.
For those who are not yet retired and in their wealth accumulation years, it is important to consider an individual or jointly owned after-tax investment account. Some refer to it as an investment “savings” account. This type of account does not provide investors with the tax benefits of a retirement account; however, you can withdraw funds from this account much like you would from any savings account. There are no penalties to consider and the money you withdraw is not considered taxable income.
Simply put, funds are deposited, invested, and over the long term, they grow while providing you the flexibility to access your money at any time.
The only consideration that separates this account from retirement savings is the tax treatment on withdrawals. As positions in this investment savings account are sold, they are subject to short- and/or long-term capital gains. If you hold a position for less than one year, the short-term gains are taxed at roughly 20%. If you hold a position for one year plus one day, the long-term gains are taxed at roughly 15%, although these rates can vary. Capital gains rates can sometimes create less of a tax burden than income tax.
Additionally, some investors will utilize this type of investment account to “harvest” tax losses when seeking a year-end tax write off. You can deduct up to $3,000 per year in realized losses, and in the event they exceed this amount, a carryover of the remaining amount is applied to future tax returns.
Not only does this type of investment account provide you additional investment opportunities, but it also provides flexibility in terms of having “anytime access” to the funds, along with some favorable tax alternatives. Another benefit worth noting is that nearly all broker-dealers and custodians will offer a margin line-of-credit at a negotiated interest rate on an investment savings account. This margin offers you access to funds without having to sell your investments. Instead, they are held as collateral for the amount available to borrow. Think of it as a home equity line of credit where the equity in your home is leveraged. In a margin account, the securities are leveraged to provide a source of funding to you.
Any time you can maximize savings for retirement you will benefit over the long-term. Starting early and saving consistently will have the biggest impact on your ability to retire early. With that said, it’s not a one-size-fits all when it comes to retirement savings just as it is not a one-size-fits-all in choosing a healthy lifestyle. The design of your retirement savings portfolio should be an integral part of your long-term financial planning.