So you’ve decided to forego the big corporation for a small business, or your own business, but now you don’t have access to a 401K plan, let alone a pension. This doesn’t mean you can’t save for retirement. There are still ways that you can shelter your income from taxes and have the money you need for retirement.
The first thing to do is to start a personal IRA – either a standard IRA or a Roth IRA. An IRA is an Individual Retirement Account, which is a tax sheltered account with specific contribution limits designed to encourage individuals to save for retirement through preferential tax treatment. 401K’s were modelled on IRAs – 401K plans just have bigger contribution limits and often have a company match to investments the employee makes – so you get the same tax advantages from investing in an IRA as you do in a 401K.
Contributions to a standard IRA are tax deferred, meaning they reduce your effective income for the year by the amount you contribute, but you then pay taxes on your withdrawals when you are of retirement age as if it were employment income. For example, if you were in the 15% tax bracket and contributed $1,000 to an IRA, you’d reduce your taxes by $150 (15% of $1,000). If that $1,000 grew into $20,000 over the next 40 years in the IRA, and you were still in the 15% tax bracket when you retired and withdrew the money from the IRA, you’d then owe $20,000 x 0.15 = $3,000 in taxes on the money. In the mean time, the money has been allowed to grow for all of those years without the earnings being taxed, allowing you to compound the interest. The amount you can contribute to a standard IRA and the amount you can deduct depends on the amount of money you make in a year and whether or not you have a retirement plan at work, plus the rules change all of the time, so it is best to check with an accountant or read the rules yourself at the IRS website. For many people under 50 in 2014, the limit was $5,500, which would be 10% of a $55,000 income. This is a good start on retirement savings and far more than most people invest until they are in their late forties or fifties, meaning you’ll be way ahead of the game if you fully fund an IRA. If you’re older than 50, you may be able to contribute $6,500 per year.
A Roth IRA is just like a Roth 401k, where the contributions you make are not tax-deductible, but the money you withdraw is tax free provided you are past retirement age. Contribution limits are similar to those for a traditional IRA. (Note that the amount you contribute to a traditional IRA counts against what you can contribute to a Roth IRA, and vice-versa. Again, call an accountant to get the rules straight and save yourself a lot of money from a costly mistake.) Mathematically it usually makes sense to invest in a Roth IRA instead of a traditional IRA because you will come out ahead withdrawing your money tax-free at retirement instead of getting a tax break now and investing the taxes you save in a taxable account. This assumes that tax rates stay about the same and something like a large national sales tax or surcharge on withdrawals isn’t implemented in the future. I’m less than optimistic about taxes in the future, so I personally use a traditional IRA. A bird in the hand, so to speak.
One advantage to having retirement savings in an IRA or Roth IRA instead of a company 401K plan is that you have more investment choices. With a 401K plan, your company chooses in what you can invest and provides a limited menu of investment options. Also, the fees for the plan need to cover the costs of the plan plus a reasonable profit for the 401K administrator, so older workers may see a lot of their investment income going to fees to pay for the younger people in the plan who have small account balances, and therefore are probably costing the fund company more than they earn from those workers in fees. This is a reason to open an individual IRA as well even if you have a 401K and/or a pension plan available at work.
Even with the freedom to choose investments when you invest in an individual IRA, it is best to have the core of your IRA holdings in diversified mutual funds with low fees. This typically means index funds or index ETFs. In general fund fees should be less than 0.05% per year. Holding a large cap fund, a small cap fund, and a bond fund, or just a total stock market fund and a bond fund is a good start. For more elaborate combinations that can increase your returns, see How to Invest Your 401K Funds.
So what if you’ve maxed out your IRA contributions and still want to save more for retirement? You can still put money away in a taxable account and invest in index mutual funds or index ETFs. You will owe taxes from time-to-time, but because these types of funds rarely trade shares, taxes will be minimal and most of your investment will continue to compound. Be wary about selling shares of your funds, however, to do rebalancing and other maneuvers since that may trigger taxes. It is better to maintain your desired ratios in your different funds by directing new money to funds that are underrepresented.
You can also achieve tax deferment by holding shares of individual companies for long periods of time. So long as you don’t sell shares of a stock, and are not forced to sell due to an event such as a corporate buy-out, you will not need to pay capital gains taxes and your investment can continue to compound. If you do find that you need to sell because the position gets too large or you feel that your money would be better invested elsewhere, you might need to pay a sizeable amount in capital gains taxes. Any dividends generated by the company would also be taxable, even if you reinvest the dividends.
Contact me at email@example.com, or leave a comment.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.