Getting Started: Investing Tax-Deferred
If saving for retirement is one of your financial goals, a good place to start investing is a tax-deferred employer retirement plan [e.g., 401(k)s and 403(b)s]. (See Unit 7, Tax-Deferred Investments, for more information.) Many employers require only a minimum deposit amount (e.g., $10) per paycheck or a low percentage (e.g., 1% or 2%) of pay to enroll.
Three advantages of employer savings plans are:
In addition, almost 80% of 401(k) plans and about 30% of 403(b)s provide employer matching. For every dollar a worker contributes, an employer might contribute a quarter, fifty cents, or even a dollar. This is “free money” that should not be passed up, if at all possible.
If you’re already investing in an employer plan, consider increasing the amount contributed by 1% (or more) of pay. The most painless time to do this is when you receive a promotion or raise because you’re already accustomed to living on less and won’t miss the extra contribution. The extra savings (e.g., 2% of pay), combined with a pay raise, should be more or less “a wash.” As chef Emeril Lagasse of the Food Network would say, “Kick it up a notch!” Over time, the extra amount of savings that will accumulate is impressive, especially for younger workers and workers at higher salary levels. According to Boston-based Advantage Publications, a company that produces financial education materials including a slide rule-type chart called the 401(k) Booster Calculator, investing just 1% more of your pay can translate into tens of thousands of extra dollars by retirement age.
As an example, 1% of a $30,000 salary is $300 ($5.77 weekly). According to Advantage Publications, if a 35-year-old worker earning a $30,000 salary increases his/her contribution to an employer plan by 1%, he/she would have an additional $55,680 at age 65. This example assumes an 8% average annual investment return and 4% average annual pay increases. If the extra 1% increase also triggers an additional 1% match by their employer, this figure can be doubled to $111,360.
The beauty of investing in employer plans is that you are using pre-tax dollars. For every dollar you invest, Uncle Sam subsidizes this investment by that amount multiplied by your tax bracket. For example, if you contribute $1,000 to an employer plan and are in the 15% marginal tax bracket, your after-tax cost is only $850 [$1,000 – ($1,000 x 0.15)]. In the 25% marginal tax bracket, the out-of-pocket cost is even less: $750 [$1,000 – ($1,000 x 0.25)]. Most employers adjust workers’ withholding to reflect this tax savings, thereby freeing up more money in each paycheck to invest. In addition, taxes are deferred on investment earnings, which provides increased growth of principal over time.
If you don’t have an employer plan, or have “maxed out” contributions to an employer plan and are looking for another tax-deferred investment, consider an individual retirement account (IRA). The good news for IRA investors with small dollar amounts is that you don’t have to invest the maximum allowable contribution all at once ($6,000 in 2020 and, thereafter, to be adjusted for inflation in $500 increments. Additional catch-up contributions are available for persons age 50 and older). You simply need to meet the minimum amounts (e.g., $250 or $500) required for the investments you select (e.g., a zero-coupon bond or mutual fund).
One way accumulate IRA money, for example, $2,000, by year-end is to open a “Holiday Club” at a local bank. Simply deposit $40 weekly in a club plan throughout the year and you’ll have $2,000 ($40 x 50 weeks) for an IRA deposit when the last coupon is clipped. In 2020, you can put $6,000 a year in an IRA or about $115 a week ($115 x 52 weeks). As discussed in Unit 7, there are two types of IRAs: a traditional (deductible or non-deductible) IRA and a Roth IRA. To choose the type of IRA that will provide the highest amount of after-tax income, consult an online IRA calculator or check with a financial advisor.