It’s no surprise that spending is sexier than saving; but there is nothing sexier than preparing for your financial freedom through a retirement savings plan.
We are human and always have some “justification” for spending instead of saving. Sometimes we gotta take that trip, get those beautiful shoes, or splurge on a family gift. We should celebrate when we have the means to do it, but Americans seem to want to celebrate without the funds to back it up. Those shoes won’t look as cool when you’re living in your kids’ basement because you can’t afford to live on your own. Thinking that far ahead is difficult for us. We want it and we want it now. But what if I told you that if you want a secure future, you’re going to have to invest in it now. Yes, right now.
1. The Welfare System Will Not Provide You a Comfortable Lifestyle in Retirement
I want to preface that there is nothing wrong with using welfare (officially, Temporary Assistance to Needy Families) for aid if you need it. Especially after you pay into the system for years, people have entirely earned their right to cash in on welfare when they meet the requirements. Although there is this safety net waiting for you at the end of your work career, it is a) pretty minimal, and b) not enough to provide a comfortable life when you’d be more likely to want to be most comfortable. Think about it: would you rather be sleeping on a futon at 30 saving money for retirement, or sleep on a futon at 70 trying to scrape by to survive? Both futons are uncomfortable, but one can sleep more soundly knowing their wealth is growing safely while they sleep.
It’s also an issue when you are older, because you will not be able to make as much as you could when you were middle-aged. Unfortunately people aren’t hiring retirees very often, so with that limitation, just imagine how little money you would have to live with the basics. Does that scare you? Have no fear! Time is on your side, and the sooner you invest, the sooner you can accrue invaluable interest.
2. You won’t to have to live with your children just because you can’t afford to live on your own.
If you have children, you probably wouldn’t mind spending as much time with them as you possibly can. But – for the most part – you probably also want that to be at your discretion. Having to live with the kids because you don’t have the financial resources to live on your own isn’t how most people want to spend their retirement years, regardless of whether your children feel you are a welcomed responsibility or a burden they simply cannot afford. Being financially dependent not only means depending on someone else to cover your living expenses, but it may also mean giving up your freedom and your independence.
According to studies I’ve read, the cost of caring for a parent who has not provided for themselves ranges from $250,000 to $700,000 in lost wages, opportunities and out-of-pocket expenses. People may have to quit jobs to care for a parent or hire care at a cost of up to $100,000 a year. Most American families simply cannot afford this kind of care for their parents, even if they want to be their sole provider. Spending time with family is very important, but at what cost when you’re in your golden years?
The vehicles in which you can save are broad and varied, but they all fall into two key categories; tax-deferred and non-tax deferred. Non-Tax Deferred savings is when you manually save your money in a savings account, but you still pay income tax on that money. While saving is generally a good thing to do, the compound effect of saving in a tax-deferred account cannot be overstated because it:
- Saves you money by not being liable for paying income tax as the money is taken out of your account before taxes are applied. That means extra $$ to save!
- Generates the compounding effect of earnings-on-earnings, which is a feature not available in a traditional savings account
3. Saving in a tax-deferred account reduces your income taxes.
If you make deductible contributions to a traditional IRA, it reduces the income that you have left because you must take funds from your savings in order to make that contribution. This sounds complicated, but is easy to determine with a Roth IRA calculator. It is important to note that Roth IRA contributions are limited for higher incomes, so if you are just starting retirement savings and are resting in 5 figure salaries, we recommend investing in a 401(k) plan. If you make salary deferral contributions to a 401(k) plan on a pre-tax basis, this reduces the amount of take-home pay you receive. However, the net effect is less than the amounts you contribute to these plans because the amount by which your income is reduced is less than the amount you contribute.
As the saying goes, show me the money! To better understand how 401(k) plans work, let’s look at some concrete examples from Investopedia:
- Adam earns $50,000 per year.
- His income tax rate is 25%.
- He gets paid on a weekly basis.
- He contributes 10% of his salary to his 401(k) account each pay period.
- Adam’s weekly contributions to his 401(k) will be $96.
- His paycheck would be reduced by only $72.
- Betty earns $100,000 per year.
- Her income tax rate is 28%.
- She gets paid on a weekly basis.
- She contributes 10% of her salary to her 401(k) account each pay period.
- Betty’s weekly contributions to her 401(k) will be $192.
- Her paycheck would be reduced by only $138.
If the thought of “free” money being saved doesn’t interest you, this certainly will: these contributions reduce the amount of income taxes you pay. That means you save money in a growing investment, and save money come tax season. There simply is no downside from saving with a 401(k) instead of a traditional savings account, except the fact that you will miss the opportunity to spend money you probably shouldn’t elsewhere. Bummer!
4. Saving in a 401(k) or Roth IRA produces a compound effect (ie: more money for you, later!)
If you add your savings to a regular savings account, the earnings that accrue on those amounts are taxed in the year those amounts are earned. This reduces the amount you have available to reinvest by the amount of taxes you must pay of these amounts.
Let’s look another example.
Assume you invest $50,000 and it accrues earnings at a rate of 8%. This produces earnings of $4,000. If your tax rate is 28%, that amounts to $1,120 that is paid to the tax authorities, leaving $52,880 to reinvest. We can also go back to the example in No. 3, which not only shows that you would pay less taxes, but that the value of your investments after tax would be even greater as a result of the compound effect of tax-deferred growth:
- Net $617,767.55 if you saved the amount in a tax-deferred account
- Net $568,732.24 if you saved the amount in an after-tax account
These numbers are compelling and get even more so when the earnings period is longer and the amount saved greater.
The Bottom Line
If you are eligible for a Roth IRA or work for an employer that offers Roth 401(k), I suggest to consider those two options. Saving is important regardless, but if you are eligible to contribute tax-deferred payments, the obvious route is to go through your employer for a 401(k) or Roth IRA. Regardless of which type of retirement account suits your specific financial background, compounding interest could be your easy pass to a financially secure and independent retirement. If you are not eligible for a Roth IRA or 401K, I also suggest Ally Bank Savings Account, which is a free banking service that is completely run online. You can earn 2.20% in interest in a savings account that has no annual fee. Can you taste the freedom from your Miami beachfront home now?
If you want to learn more about how to prepare a 401(k) or a Roth IRA to prepare for your retirement? Set up a personal consultation today with me and if I can’t save you $500, your consultation is free! Click the big green button below and let’s make your life greener with more wealth and more financial freedom for your future!