You should not wait until you are on the verge of retirement to develop a plan for it. If you can put aside some of your income throughout your career, you will have a more stable future once you retire. Some common options include 401(k) or 403(b) plans, IRAs, and Roth IRAs or 401(k) plans. An employer also may offer a retirement pension or another type of defined benefit plan if you have spent enough years working for that employer.
A 401(k) or 403(b) plan involves the employer withdrawing a certain amount from the employee’s paycheck automatically, based on how much the employee wants to designate for their retirement. You can choose how the funds in these plans will be invested, depending on your tolerance level for risk. These plans impose limits on how much an employee can contribute each year. By contrast, an IRA (Individual Retirement Account) may or may not be sponsored by an employer. You can create your own IRA, and your contributions will be tax-deductible if your income is below a certain amount or if your employer does not offer a 401(k) plan. Like 401(k) and 403(b) plans, an IRA has a limit on how much you can contribute each year. The limit is much lower than the limit for 401(k) and 403(b) plans.
Tax Advantages in Retirement Plans
You will not need to pay income tax on funds that you contribute to a 401(k) or 403(b) plan. You will need to pay tax on withdrawals that you make during retirement, but you still will come out ahead overall. This is because your take home pay will be reduced by less than the amount by which it would have been reduced if you had paid taxes on the portion that you contributed to the fund.
Traditional 401(k) or IRA = contributions are not taxed, but withdrawals are Roth 401(k) or IRA = contributions are taxed, but withdrawals are not
Roth plans take the opposite approach to taxes. They permit taxes on contributions, while making withdrawals tax-free. Therefore, Roth plans can be appealing to younger employees who will have their money in the plan for longer, allowing it more time to increase. They also can work well for people who will need to pay substantial taxes when they retire.
Other Reasons to Develop a Retirement Plan
In many situations, an employer will match an employee’s contributions to a retirement plan. An employer match may be determined by a set dollar amount, or it may amount to a percentage of your salary. There is no downside to an employer match. However, it may not take effect until you have spent a certain number of years working for that employer. If you do not plan to stay at a certain company for the long term, an employer match may not matter much to you.
The younger that you start saving the better, and you will never be younger than you are today.
A retirement plan also can allow you to collect compound interest, especially if you are relatively young when you start your plan. This is because interest will start building once you invest in a retirement plan, and then interest will build on top of the interest. In other words, if you put $10,000 into a plan and earn 10 percent interest each year, you will have $11,000 a year later. Another year after that, you will have $12,100, and so on, even if you do not add any more money to the plan. Starting the plan when you are younger allows you to accumulate more interest over time.