A 401(k) plan is designed with retirement in mind. For younger employees, hearing the word “retirement” can seem like a lifetime away, but the cliché is true – it will be here before you know it.
Taking advantage of a 401(k) is a great way to plan for your retirement and if you’re not familiar with 401(k)s, read on to learn more.
401(k)
- Tax advantaged
One of the highlights of a traditional 401(k), is that funds are deducted on a pre-tax basis. Meaning, if you are contributing $50 out of your paycheck to your plan, your net paycheck will not be reduced $50, but an amount less than that (depending on your withholding).The funds grow in the account on a tax-deferred basis. For many people, when the funds are later withdrawn in retirement, individuals may be in a lower tax bracket and may be taxed less, depending on their situation.*
- Free money
Would you turn down a raise from your employer? As many employers provide a matching contribution to your 401(k), by declining to participate in your retirement plan you may be turning down free money!
While the funds you contribute are always yours, employers may have a vesting schedule for funds that they have contributed on your behalf. Ask your employer about their 401(k) benefits so you can take advantage of any available match.
- Tax credit
Currently, contributions to a retirement plan could qualify for a tax credit. If you qualify for this credit, 10, 20 or even 50% of your contribution could be given back to you in the form of a tax credit under the Retirement Savings Contributions Credit.
This credit is based on adjusted gross income as reported on your Form 1040 series return. More info on this credit can be found with the IRS.
- Time is on your side
Depending on your plan, your earned interest may compound daily, monthly, quarterly, or annually. This means you earn interest on your interest. With time, this can really add up.
Another way to leverage time is to increase your annual contributions by 1% per year. If you start off contributing 4%, within a short 5 years, you could be contributing 9% per year. Paired with an employer match, this can add up quickly. With the possibility of receiving money from your employer, tax advantages and compounded interest, why delay in enrolling in your 401(k)?
*Please note: consult your trusted tax advisor and financial advisor to discuss how these concepts may apply to you.
Let’s Talk Saving for College
According to Educationdata.org, the cost of attendance at an average public 4-year institution in Ohio is $24,423 for in-state students. Considering this staggering figure it’s no wonder that many parents want to get a kick start on saving.
Thankfully there are many options to save for college, including 529 plans, custodial accounts, Coverdale ESAs and gifting funds.
Starting early is the key. Opening an account when a child is born and investing $5,000 a year could potentially grow to $200,000 by the time the child is ready for college.
Delaying saving until the child is 12 bumps up the annual savings needed to over $25,000. (This is estimating an 8% rate of return for illustrative purposes.)
529 Plans
The most popular option for college savings is a 529. This plan allows you to make after-tax contributions to the account which grow tax deferred.As long as the funds are used for qualified expenses which include tuition, fees, books, supplies, equipment, computers, and sometimes room and board, the funds are withdrawn tax free.
529 plans are generally flexible and low maintenance. The funds are controlled by the account owner, not the child.
Custodial Accounts
Custodial accounts are often called OTMA, UGMA or UTMA. Assets invested in a custodial account can be used for any expense that benefits the child and are not restricted to only college expenses.
While the flexibility of custodial accounts is a major attraction, parents need to be aware that at the age of majority (age 18-21) the funds are the child’s asset. If the child decides to spend that money on a vacation, car, or something else of their choosing, there is nothing the parent can do to stop it.
Coverdale Savings Accounts
An often-overlooked option is a Coverdale Savings Account (also known as an ESA). Like 529 plans, funds may be contributed after tax, grow tax deferred and as long as funds are used for qualifying education expenses, they may be withdrawn tax free. Unlike 529 plans, Coverdale accounts have a maximum contribution limit of $2,000 a year.
Gifting Funds
Lastly, some parents decide to set aside funds earmarked for college but keep funds in their own name until the need arises. This option allows the greatest flexibility for the parent to decide if and when funds are used for the child’s benefit.
But be aware, this comes with giving up some of the potential tax advantages of the other choices previously shared. It should be noted that many parents decide to support their child’s educational journey in non-financial ways (providing emotional support, helping them navigate student loans, etc.).
Remember that while student loans exist to finance education, financing options do not exist for retirement. When making the choice between funding a child’s college expenses or retirement, experts agree that retirement should take priority.
*Please note: consult your trusted tax advisor and financial advisor to discuss how these concepts may apply to you.
