Annual Contributions to Your Retirement Account
Most working people have some form of retirement account at their place of employment; for those who are self-employed or who work at such small establishments that there is no company plan, there are other options to establish tax-advantaged retirement plans. There’s no excuse not to have a retirement account!
Tax-Free Retirement Accounts
Retirement accounts are by definition tax-advantaged. Generally, money that is put into a retirement account is not taxed — annual contributions are deducted from your gross income before your tax is calculated. Additionally, retirement accounts grow tax-free. The money in the accounts is usually invested in some combination of securities, bonds, and cash instruments, and these investments are allowed to grow tax free as long as the money remains in the accounts. Retirement accounts are only taxed, as regular income, when you begin to make withdrawals.
Tax-Free Growth Retirement Accounts
Individual retirement accounts, or IRAs, which anyone earning income can set up, work in similar fashion. However, a special kind of IRA, the Roth IRA, works differently. Annual contributions are not tax deductible. However, Roth IRA accounts grow tax-free, just as regular retirement accounts do, and all withdrawals after you reach retirement age are likewise completely tax free. If a substantial portion of your wealth is invested in a Roth IRA and you plan to live on withdrawals once you’re retired, you will pay negligible taxes.
IRS Limits on Tax-Free Retirement Account Contributions
A question that many people ask is, ‘How much should I put in my retirement account each year?’ The short answer is, as much as you comfortably can. However, because the accounts are tax advantaged, the Internal Revenue Service limits the amount of annual contributions. The limits are adjusted from year to year, so pay attention to these limits and contribute as much as you can without exceeding the annual limits. If you contribute too much, you may owe a penalty to the IRS.
If you have a 401(k) plan or other defined-contribution retirement account at your place of employment (including Thrift Savings for U.S. federal employees), the annual limit for contributions (in 2012) is $17,000. Note that this sum does not include any matching contributions that your employer might be offering. If your employer offers matching contributions, contribute at least as much as you have to to qualify for the match; it’s free money! And, if you’re 50 or older, you can contribute an additional $5,500 annually as a “catch-up contribution.”
Whether you have a 401(k) or not, you are also eligible to open an IRA account on your own, as long as you have earned income. There are also annual limits on IRA contributions. In 2012, for those under 50 years of age, the limit is $5,000 or the total amount of your taxable compensation (earned income) for the year, whichever amount is smaller. For those 50 and older, the limit is $6,000 or the total amount of your taxable compensation, whichever is smaller. The same limits apply to regular IRAs and Roth IRAs.
Following from the above, an employed person over the age of 50 can contribute up to $28,500 in retirement accounts during tax year 2012. That’s a substantial amount, and you should save as much of that as you can. If have extra cash after contributing the maximum into retirement accounts, you can save additional money in taxable accounts — no limits there — but make some effort to invest this extra money in investment products that are “tax friendly.” For instance, some mutual funds aim to decrease their tax burden by buying and selling their holdings as infrequently as possible, thus minimizing capital gains taxes.
Paying Off Credit Card Debt Should Be a Priority Vs Retirement Savings
There may be reasons why, some years, it makes sense to save less. If you have high credit card debt at high rates of interest, for instance, it usually makes sense to pay down your balances before putting extra cash into savings. The 15 percent or more you’re paying on your credit card balance is likely more than you would earn in a retirement account on the same money, so pay down the balance first. However, because a mortgage on your home is tax deductible, it usually makes more sense to put money away for retirement before making extra payments against your mortgage. Rates on mortgages and home equity lines of credit, also, are much lower than credit card interest.
To answer the question “How much should I put in my retirement account each year”: Put away as much as you can, within the limits established by the IRS, without substantially sacrificing your quality of life in the meantime. There is such a thing as saving too much. If you’re saving so much that you’re forcing yourself to lead a spartan lifestyle, it may not be worth the sacrifice — find a way to eke some pleasure out of your life during your working years, while having enough money left over to fund a comfortable life during your retirement years.