By Katelyn E. Murray, CFP®
Carpe diem—seize the day! It’s an inspiring phrase, but unfortunately not one we apply to our retirement savings too often. Look, I get it. I’m a financial planner—I’m probably not ever going to tell you it’s a bad time to fund your retirement accounts… That said, there are a couple of reasons why right now is a particularly great time to do so (you know, other than your New Year’s resolution to be more responsible with your money).
If not now, when? You may have heard the phrase “investing is not about timing the market, it’s about time in the market.” While your chances of making millions overnight by picking the next big stock are pretty low statistically speaking, investing as early as possible in retirement accounts like a 401(k), 403(b), or the federal government’s Thrift Savings Plan (TSP) through your employer, or an IRA or Roth IRA on your own, could have significant benefits.
Having more time to grow your assets can often give you the flexibility to take on more risk, and we all know that higher risk can mean greater returns over time. More time also means more compounding interest—in other words, interest earned on interest. By investing early and then reinvesting your earnings for further growth, you can exponentially increase your returns.
If 25-year-old Susan invests a $5000 lump sum in her IRA today and that lump sum earns an average of 10% interest over time, Susan will have turned that $5000 into $87,247.01 by the time she reaches age 55. By age 65, she will have $226,296.28. And that’s with no further contributions beyond the initial $5000 investment! That is the power of compounding interest. Now imagine if Susan saved $5000 to her IRA every single year—it adds up!
You can actually save more now. Periodically, the IRS increases annual contribution limits for retirement accounts, and last month, they officially announced that they are increasing the limits for some types of retirement accounts for 2022. Employees who participate in 401(k), 403(b), most 457 plans, and the TSP can now contribute $20,500 per year (compared to $19,500 per year in 2021). Employees who are over age 50 can contribute an additional $6,500 per year as a “catch up” contribution to their plan, for a total annual contribution of $27,000. Annual limits on contributions to Traditional and Roth IRAs remain unchanged at $6,000 ($7,000 for those over age 50).
Worried about the Biden Administration increasing taxes? Fund your retirement accounts and reduce your taxable income for the year. There’s a lot of talk about the proposed changes to federal taxes. As I tell clients, the reality is that the proposed changes will likely undergo a significant metamorphosis as the legislation moves through Congress, so at this point, we really don’t know what the exact outcome will be.
That said, if you’re worried about your tax liability for 2022 and beyond, funding your pre-tax retirement accounts can be a great way to reduce your overall income! Max funding a 401(k) plan through work with $27,000 (assuming you’re over 50 years old) could bring a single filer making $100,000 per year down from the 24% tax bracket to the 22% tax bracket even before the standard deduction is applied.
Of course, it’s also important not to let the “tax tail” wag the dog—you don’t want to forget about the importance of saving to the Roth option in your 401(k) or funding a Roth IRA in addition to your employer plan so that you have some after-tax money to rely on in retirement in case tax rates rise once you’ve retired. A financial plan can help you navigate the balancing act between managing both your current and potential future tax liability.
Direct deposit makes it easy and less painful to save to your employer-sponsored retirement plan. You can set up your contributions online or through your payroll office and then set your retirement funding on autopilot (although please make sure not to set your investment allocation on autopilot—it matters how your funds are invested!).
You’ll definitely need this money in retirement, but you might need it even sooner than you think. Ideally, you won’t touch this money until you’ve put the keys on the table and you’re on a flight to Cabo to celebrate never having to commute to the office again. But if there’s one thing that we’ve all learned over the past year and a half of a global pandemic, it’s that life can change in an instant.
While it’s definitely not encouraged to take money out of your retirement accounts before you’ve actually reached age 59 ½, to avoid the early withdrawal penalty, this can be an option as a last resort… and it’s an option you don’t have if you never bothered to fund your retirement accounts. This type of situation is where a well-funded Roth IRA can really be a saving grace—especially considering that you can take out up to 100% of the principal amount invested in a Roth IRA with no early withdrawal penalty or taxes due, assuming the Roth IRA has been open for at least five years. Again, this isn’t something you should aim to do, since the value of leaving the principal in the Roth IRA to grow tax-free for decades is the whole draw of these types of accounts, but funding a Roth IRA does give you an option in desperate times that you would not have otherwise.
About the author: Katelyn E. Murray, CFP®, FBS®, CFT-I™
Katelyn E. Murray, CFP®, FBS®, CFT-I™ is a fee-only, fiduciary financial planner and behavioral coach with nearly a decade of experience helping clients define their own vision of success and build a reliable path to reach it. Katelyn uses her background in financial psychology and behavioral finance to cultivate an integrated financial planning approach, in which behavioral coaching elements are integrated with traditional planning and wealth management expertise. As a public speaker, she has appeared as a guest on The W Pulse podcast and has been invited to speak at a number of industry conferences nationwide, including Advisor Group’s ConnectED conference and The W Forum.