When you’re starting your career, just paying your bills can be a financial challenge. It’s difficult to begin saving for the future when every dollar seems to be committed to your current household expenses. A great way to take more control over your finances is to prepare a monthly budget. Once you start tracking your income and spending, you may be able to shift some of those dollars in a savings account or money market fund.
Along with managing your personal finances, you should also start contributing to a qualified retirement account, such as a 401(k) plan offered by your employer, an individual retirement account (IRA) or a SEP-IRA if you are self employed.
If you are in your 20s or 30s, a comfortable financial retirement may seem like a distant goal. But the years pass quickly, and getting an early start on your retirement savings can make a big difference in your financial future.
One of the best ways to save for retirement — regardless of age — is maximizing your contributions to your employer’s 401(k) or a similar “defined contribution” plan. Unlike a traditional corporate pension plan, you are responsible for accumulating a retirement nest egg through your contributions.
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A recent study from the National Institute on Retirement Security on “Millennials and Retirement: Already Falling Short,” found that more than half of Millennials have nothing saved for retirement, including 83 percent of young Hispanic employees.
While 66 percent of Millennials, born between 1981 and 1991, work for an employer that offers a retirement plan, only 34.3 percent actually participate in their employer’s plan. That’s a missed opportunity for many young workers.
Good reasons to contribute
There are good reasons why putting as much as possible into your qualified retirement plan, makes financial sense. First, every dollar that you contribute can usually be subtracted from your annual gross income, reducing your current income tax liability.
For example, let’s say you’re a single person who expects to make $60,000 in taxable income this year. Under the 2017 tax law, you would likely owe $9,138 in taxes next year, not counting any deductibles.
But if you contributed $6,000 or 10 percent of your total income to your 401(k), your taxable income would be only $54,000. That would reduce your tax payment to $7,819, giving you an extra $1,319 to save or spend in 2019.
This is just a hypothetical illustration, and you should talk with a tax professional or financial advisor to discuss your individual situation. However, the basic principle remains the same: every dollar you contribute will lower your current income tax liability.
So, what’s the catch? You will need to pay the difference in taxes at some point later in life. However, if you make those withdrawals at age 70 or above in retirement, you may be in a lower tax bracket compared with your peak earning years. In the meantime, those dollars you contribute can grow tax-free through the decades based on your long-term savings and investment plan.
A second reason for putting money into your 401(k) is that many employers will match a portion of your contributions. For instance, if you contribute 10 percent of your income, your employer might add another 5 percent to your retirement plan.
If you contributed $6,000 to your account this year, as in the previous example, you would get an extra $3,000 as well. That means you would be able to put away $9,000 for retirement in just one year, with the potential for even more employer contributions in the future.
In many ways, an employer’s contribution to your 401(k) is even better than an annual bonus. After all, you would have to pay income tax, reducing the take-home amount of your bonus. It’s also tempting to spend that bonus right away, rather than saving those extra dollars.
So, after you get your monthly bills under control, start making contributions to a qualified retirement plan. Your employer can usually deduct those funds from your regular paycheck, along with your withholding tax and any insurance premiums.
If you get a raise in your salary or another boost to your income, think carefully about increasing the level of your contributions to your retirement plan. Take advantage of the nation’s tax laws, as well as any benefits from your employer, in order to reduce your current taxes and save as much as possible for the future.
Andrew Menachem, CIMA®, is a Wealth Adviser at The Menachem Group at Morgan Stanley in Aventura. Views expressed are those of the author, not necessarily Morgan Stanley, and are not a solicitation to buy or sell any security. The strategies and/or investments referenced may not be suitable for all investors. Follow Menachem on Twitter @AMenachemMS.