When should you start planning for retirement? Many people start saving in their 20’s but it is never too early or too late to start. Fortunately the tax law provides subsidies to help people save for retirement. Below are 10 ideas for you to consider as you are either starting your journey, towards the end, or just want to review how you are doing.
1. Set up an emergency reserve
Bad things do happen from time to time. Without an emergency reserve fund, many people have to dip into their existing retirement savings when faced with an unplanned event such as unemployment, surgery or other emergencies that might come along. In 2009 when the unemployment rate skyrocketed, many people who had lost their jobs didn’t have an emergency fund, which meant they had to sell their securities after they plunged due to the Great Recession. So how much should you save in your emergency fund? Experts at Mint.com say you should save three to six months of post-tax income in a taxable account.
2. Get tax credits for your retirement savings
It almost sounds too good to be true, but if your adjusted gross income for 2014, for example is less than $60,000 (married filing joint), or $30,000 for single taxpayer, then you would be eligible for the Saver’s tax Credit on your federal return. The exact amount of the credit depends on the amount contributed and the amount of your income. The taxpayer must also have some earned income. If your income is too high to qualify for this credit, your child or grandchild might qualify for this tax benefit.
3. Tax Deferred Plans
If your income is too high for the Savers Tax Credit, the IRS will still subsidize your contribution to a traditional IRA, 401k plan, or SEP plan, for example. You would make this contribution and either get a tax deduction on page 1 of form 1040 (which reduces your adjusted gross income) or the amount on your form W-2 will be reduced. When you withdraw the funds, the distributions will be taxed at ordinary rates for federal and California purposes. CNN Money discusses this topic.
4. Allocate a “Special” Savings Account for Life Purchases
Everyone has large purchase goals in life so it is important to distinguish between savings for those goals and savings for long term retirement. If you want to buy a house or start a business you want to have access to your savings, thus it is important to NOT put all your money into a tax advantaged retirement account. Daily Finance covers a good article about saving for a home.
5. Create a Roth IRA or Enroll in a Roth 401k Plan
Consider creating a Roth IRA or enrolling in a Roth 401k plan. You would contribute after tax money, but the savings would compound tax free, similar to a traditional IRA. However, unlike a traditional IRA, when you withdraw the funds from the Roth account, the distributions would not be taxable. RothIRA.com delineates the particular Roth IRA limits . Unlike a traditional IRA, where distributions must commence when the taxpayer is 70 ½, there is no requirement to take distributions from the Roth account in your life time, the details of which are also explained by RothIRA.com Minimum Distribution Article.
The maximum IRA contribution for 2014 is $5,500. If you are age 50 or above the maximum contribution would be $6,500
6. Convert To a Roth IRA as a High Income Individual
Do you want to have a Roth IRA, but your income is too high? With the ability to convert a traditional IRA to a Roth IRA, anyone can benefit from a Roth IRA. In a Roth Conversion, a taxpayer must pay the tax at ordinary rates in the year of conversion based on the value of the account on the day of conversion that exceeds the tax basis of the IRA. Let’s say for example that Jane:
i. Earns $250,000 a year as a wage earner and she benefits from a profit sharing plan that her employer sponsors.
ii. She has no other traditional IRA account.
iii. Jane is age 51 in 2014.
Her income is too high to make a regular Roth contribution. But if she contributes $6,500 to a nondeductible traditional IRA in 2014, she can immediately convert the account to a Roth. If the value of the nondeductible traditional IRA increased to $6,502 before the Roth conversion is complete, then since her tax basis in the IRA was $6,500, then she would only have $2 of ordinary income to recognize on the Roth conversion. Jane could do this every year.
However, if Jane had a traditional IRA, the calculation of the ordinary income from the Roth conversion would be more complicated. Jane could also convert her traditional IRA to a Roth IRA, but the taxes would be more significant. Jane should seek advice from her CPA before doing a Roth conversion if either of these two cases applies to her.
7. Make regular consistent contributions to your retirement account
Make regular consistent contributions to your retirement account. While market volatility may make you leery of putting more into your retirement plan, for most people it’s advantageous to do so, especially in bear markets.
When the value of stocks is low, you can buy more shares for the same amount of money. This is easier to understand if we look at a consumer item. If a dress was marked down 60%, would Jane (see above item 6) hesitate to buy the dress? Would Jane feel more comfortable waiting to buy the dress when the price increases to full price? Of course she would not feel better paying full price.
But that behavior does not seem to follow when the stock market is in a bear market. For instance, when the Great Recession of 2008 and 2009 occurred many people stopped contributing to their retirement plans when the stock market was half of the previous market high in 2009. (Remember all of the comments about the 201K plan, when the account values had dropped by 50%?) Others sold all their investments in 2009 so they would not lose any more money. Investors said they wanted to get back into stocks when the volatility in the market had ended. Investment professionals say the best opportunities to invest is when emotional risk is high because the investment risk is low.
8. Take Advantage of “Free” Money
If your employer offers a match for your 401k contribution, you should contribute enough each year to get the maximum match. If you don’t you are essentially turning down “Free” money.
9. Diversify Your Investment
Diversification offers not only some safety during market declines, but it also offers higher potential returns over the long run. Investopedia offers five tips for diversifying your portfolio.
Consider disability insurance, long term care insurance and life insurance. Life insurance can be incorporated as part of your estate planning. Make sure to talk to your attorney and tax advisor when choosing insurance vehicles.
If you are 25 then time is on your side. The earlier you start saving, the less you will need to save each month and each year. It is important to review your plan with an advisor regularly. I have briefly commented about the 10 ideas for saving. You should consult your tax advisor to learn more about the complete tax ramifications of these ideas before taking any action.