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      Grappling with retirement account concerns

      There are legitimate concerns about putting money into a retirement account. First and foremost is the fact that once you place such money inside a retirement account, you can’t generally access it before age 59½ without paying current income taxes and a penalty — 10 percent of the withdrawn amount in federal tax, plus whatever your state charges.

This poses some potential problems. First, money placed inside retirement accounts is typically not available for other uses, such as buying a car or starting a small business. Second, if an emergency arises and you need to tap the money, you’ll get hit with paying current income taxes and penalties on amounts withdrawn.

      

You can use the following ways to avoid the early-withdrawal penalties that the tax authorities normally apply:

       You can make penalty-free withdrawals of up to $10,000 from IRAs for a first-time home purchase or higher educational expenses for you, your spouse, or your children (and even grandchildren).

       Some company retirement plans allow you to borrow against your balance. You’re essentially loaning money to yourself, with the interest payments going back into your account.

       If you have major medical expenses (exceeding 10 percent of your income) or a disability, you may be exempt from the penalties under certain conditions. (You will still owe ordinary income tax on withdrawals.)

       You may withdraw money before age 59½ if you do so in equal, annual installments based on your life expectancy. You generally must make such distributions for at least five years or until age 59½, whichever is later.

      

If you lose your job and withdraw retirement account money simply because you need it to live on, the penalties do apply. If you’re not working, however, and you’re earning so little income that you need to access your retirement account, you would likely be in a relatively low tax bracket. The lower income taxes you pay (compared with the taxes you would have paid on that money had you not sheltered it in a retirement account in the first place) should make up for most, if not all, of the penalty.

      But what about simply wanting to save money for nearer-term goals and to be able to tap that money? If you’re saving and investing money for a down payment on a home or to start a business, for example, you’ll probably need to save that money outside a retirement account to avoid those early-withdrawal penalties.

      If you’re like most young adults and have limited financial resources, you need to prioritize your goals. Before funding retirement accounts and gaining those tax breaks, be sure to contemplate and prioritize your other goals (see the section “Setting and Prioritizing Your Shorter-Term Goals” earlier in this chapter).

      Taking advantage of retirement accounts

      

To take advantage of retirement savings plans and the tax savings that accompany them, you must spend less than you earn. Only then can you afford to contribute to these retirement savings plans, unless you already happen to have a stash of cash from previous savings or an inheritance.

The common mistake that many younger adults make is neglecting to take advantage of retirement accounts because of their enthusiasm for spending or investing in nonretirement accounts. Not investing in tax-sheltered retirement accounts can cost you hundreds, perhaps thousands, of dollars per year in lost tax savings. Add that loss up over the many years that you work and save, and not taking advantage of these tax reduction accounts can easily cost you tens of thousands to hundreds of thousands of dollars in the long term.

      The sooner you start to save, the less painful it is each year to save enough to reach your goals, because your contributions have more years to compound. Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. If saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away approximately 10 percent to reach that same goal; waiting until your 40s means saving 20 percent. Start saving and investing now!

      Surveying retirement account choices

      If you earn employment income (or receive alimony), you have options for putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to these retirement accounts are tax-deductible. This section reviews your options.

      Company-based retirement plans

      Larger for-profit companies generally offer their employees a 401(k) plan, which typically allows saving up to $19,500 per year (for tax year 2021). Many nonprofit organizations offer their employees similar plans, known as 403(b) plans. Contributions to both traditional 401(k) and 403(b) plans are deductible on both your federal and state taxes in the year that you make them. Employees of nonprofit organizations can generally contribute up to 20 percent or $19,500 of their salaries, whichever is less.

      There’s a benefit in addition to the upfront and ongoing tax benefits of these retirement savings plans: Some employers match your contributions. (If you’re an employee in a small business, you can establish your own SEP-IRA.) Of course, the challenge for many people is to reduce their spending enough to be able to sock away these kinds of contributions.

Some employers are offering a Roth 401(k) account, which, like a Roth IRA (discussed in the next section), offers employees the ability to contribute on an after-tax basis. Withdrawals from such accounts generally aren’t taxed in retirement.

      FIGURING HOW MUCH TO SAVE FOR RETIREMENT

      Numerous mass market website tools exist and focus on retirement planning. Many investment firms offer these to lure you to their websites. Some require you to register whereas others can be accessed as a “guest.” Such tools walk you through the calculations needed to figure how much you should be saving to reach your retirement goal.

      The assumptions that you plug into these calculators are really important, so here’s a review of the key ones:

       Asset allocation: Enter your current allocation (the portion invested in stocks versus bonds) and you’ll also typically select an allocation for after you’re retired. Most such calculators don’t include real estate as a possible asset. If you own real estate as an investment, you should treat those assets as a stock-like investment, since they have similar long-term risk and return characteristics. (Calculate your equity in investment real estate, which is the difference between a property’s current market value and mortgage debt on that property.)

       Age of retirement: Plug in your preferred age of retirement, within reason, of course. There’s no point plugging in a dream number like “I’d like to retire by age 45, but I know the only way I can do that is to win the lottery!” Depending on how the analysis works out, you can always go back and plug in a different age. Sometimes folks are pleasantly surprised that their combined accumulated resources provide them with a decent enough standard of living that they can consider retiring sooner than they thought.

       Include Social Security: Some calculators ask whether you want to include expected Social Security benefits. I’d rather that they didn’t pose this question at all, because you definitely should include your Social Security benefits in the calculations. Don’t buy into the nonsense that the Social Security program will vaporize and you’ll get little to nothing from it. For the vast majority of people, Social Security benefits are

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