Many people are intimidated by money, and managing it wisely may feel like a full-time job. It may seem like your money controls you, rather than you control your money. We can debate whether money buys happiness or not, but for many, there never seems to be enough money to feel financially secure.
Fortunately, there are some shortcuts to financial security. Today’s column will cover two important ones:
- Set up your savings to be automatic each month
- Take advantage of tax-free accounts
Make Your Savings Automatic Each Month
This is the “pay yourself first” strategy. Rather than hoping there may be money remaining to save at the end of each month, be proactive, and have some money automatically swept into an investment account at the beginning of each month. You will then spend the remainder, knowing you are saving consistently.
Let’s assume your paycheck is deposited into a bank checking account. If you do not already have an emergency fund that will cover at least four months of expenses, have the bank transfer your monthly savings from your checking account to a savings account. If you already have an emergency fund, have your bank set up a monthly electronic transfer from the checking account to a taxable account or a Roth IRA at an investment firm, which are sometimes called a brokerage firm or wealth management firm. The electronic transfer can usually be set up by your bank or your brokerage firm, and it can often be set up online.
The same concept works for your retirement plan through your employer. Establish a percentage of your paycheck to be transferred into the account each month. These are typically called 401(k) or 403(b) plans. Most employers provide a match for a portion of your contribution, so you should contribute at least the amount needed to receive the maximum match. Often this is 6 percent, but you will need to check with your employer. For 2024, employees under age 50 can contribute as much as $23,000 to a 401(k) plan or 403(b) plan, and people age 50 and above can contribute up to $30,500.
Most employers now offer a Roth (tax-free) retirement plan as well as a traditional (tax-deferred) plan. I am a huge fan of the Roth version. Although you will not be able to take a tax-deduction in the year you contribute to the plan (as you can with a traditional 401(k) plan), the future earnings and withdrawals will be tax-free, making the Roth a better choice than a traditional plan.
When I owned a financial planning firm, many of my clients had large traditional IRAs they had accumulated over many years during their careers. These were a result of consistently saving in their employer’s 401(k) or 403(b) retirement plan. This showed they were disciplined savers, and it paid off by providing financial security and a comfortable retirement. Until Roth 401(k)s and Roth 403(b)s became available during the past 10 to 15 years, saving in the traditional plan was the only option.
The downside to traditional IRAs is that the required minimum distributions (RMDs) which are required when someone turns 73 (previously age 70.5 and changing to age 75 for those turning 74 after 12/31/32), are fully taxable as income. Many retirees with large traditional IRAs are now paying higher taxes than they expected because the RMDs, Social Security benefits and pensions are all taxable on a federal level. States vary in how they tax retirement income.
Take Advantage of Tax-Free Accounts
In 1999, Roth IRAs became available, and employers began offering Roth 401(k)s and Roth 403(b)s in recent years. The Roth versions offer investors a better choice for several reasons. First, Roth IRAs do not require RMDs, so if the retiree does not need to take withdrawals for living expenses, they can leave the money to grow tax-free during retirement in the Roth IRA. Second, withdrawals from a Roth IRA are tax-free rather than taxable. This may also reduce IRMAA (the Medicare premium penalty for high-income earners after age 65). The third major benefit involves estate planning. Since the 2017 Secure Act, IRAs that are inherited by non-spouse beneficiaries, typically children or grandchildren, must withdraw the money within 10 years after death. The withdrawals from a traditional IRA are fully taxable to the beneficiary, but withdrawals from a Roth IRA are NOT taxable to the beneficiary.
In addition to contributing to your employer’s retirement plan, you can also contribute to a Roth IRA at an investment/brokerage firm. Many people do not realize you can do both, so don’t miss this opportunity! In 2024 as long as you do not exceed the modified adjusted gross income (MAGI) limits ($161,000 for single filers and $240,000 for joint filers), you can contribute up to $7,000 if you are under age 50 and $8,000 if you are over age 50 to a Roth IRA. (If your taxable income is slightly below the maximums listed above, you may be able to make a partial Roth IRA contribution.)
You can contribute to a Roth IRA for the 2023 tax year up until April 15, 2024. You must have earned income to contribute to a Roth IRA, so retirees cannot continue to fund a Roth IRA. However, if you have children or grandchildren who have earned income—but who may not be able to afford to fund their Roth IRA—you can fund it for them. This makes a wonderful gift because you will be helping them build a tax-free account for retirement.
Although the Roth IRA was initially designed to fund retirement, the contributions (not the earnings) can be withdrawn at any time. Therefore, the contribution can be used for expenses such as buying a home, paying for college or starting a business. This provides flexibility if the money is needed sooner.
Setting up your savings to be automatic each month and taking advantage of tax-free accounts will serve you well on your journey to financial security. It’s also a great way to start a new year!
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Donna Skeels Cygan, CFP®, MBA, is the author of The Joy of Financial Security. She owned a fee-only financial planning firm for over 20 years and is now writing a new book that will be published in 2024.