While most people have heard about the importance of saving for retirement, many are still confused about the best type of retirement plan and when they should start saving. According to Richard Welling, an investment and real estate tax expert, the best time to start your nest egg is now. Adding a percentage of your paycheck to a tax-advantaged savings plan is crucial for your financial security later in life, and because these plans are tax-deferred or in some cases even tax-exempt, starting to save sooner rather than later can make a big difference in your final balance! Below are two common types of retirement savings contributions and the boundaries of each.
Traditional 401(k)
A traditional 401(k) is probably the most well-known type of retirement savings plan. With this type of plan, you can make pre-tax contributions to your nest egg, which reduces your Modified Adjusted Gross Income (MAGI) which can be helpful for your taxes because it may help you avoid net investment income tax. Assets in your 401(k) account can grow without being taxed until you begin taking distributions. This is known as tax-deferred.
Many employers match employee 401(k) contributions up to a certain percentage. Contributing the maximum percentage matched by your company is generally advisable. Not doing so is like turning down free money that your company is willing to deposit on your behalf!
Auditing your current contributions and planning to get as close to the maximum contribution threshold as possible is another way to grow your nest-egg efficiently. Keep in mind that since 401(k) contributions are pre-tax, less might actually come out of your paycheck than you think.
Roth 401(k)
Your employer may also give you the option of designating some of your contributions as “Roth.” Roth contributions do not reduce your MAGI, but are considered tax-free rather than tax-deferred.
If you make over $122,000 and file as a single taxpayer, or file jointly and make over $193,000 and cannot contribute to a Roth IRA, a Roth 401(k) might be a good option for you.
Both 401(k) and Roth 401(k) contributions have a limit of $19,500 for 2020. If you are over 50 years old, you can also contribute up to $6,500 in “catch up” contributions toward your retirement savings goals.
In order to make the determine the right kind of retirement savings for you, talk to your financial advisor about all of your options. The most important takeaway is to start saving as soon as possible to maximize the size of your nest egg by the time you reach the right age for retirement. For more information on how to make sure you’re properly planning for retirement, read our article “How to Avoid Getting Behind in Your Retirement Savings” here.
