|Eight tax-smart savings tips|
Friday, 26 July 2013 00:00Written by Viewpoint
Have you decided to save more this year? If so, you're not alone. Fifty-two percent of Americans listed "saving more money" as their top financial resolution, versus 46% last year, according to Fidelity's 2013 Financial Resolutions Study. But are you saving enough—and saving smart enough?
In general, Fidelity believes that to reach your long-term retirement savings goals you may need to save 10% to 15% or more of your earnings each year.1 That isn't easy, given the rising price of health care, education, and other costs of living—all the more reason to max out all the tax advantages available to help Americans save.
We suggest setting aside three to six months of expenses in an emergency fund. But after that, we believe saving for retirement should be most Americans’ top priority. After all, you can probably get loans to pay for children’s education, a house, a car, or other financial goals. But beyond Social Security, you’ll likely need to fund your own retirement paycheck.
Here are eight tips, not necessarily in order, to help you save more and smarter this year. Depending on your situation, you might consider some or all of these.
Get the full company match.
If you have a 401(k), 403(b), or governmental 457(b) plan, and your employer offers a matching retirement contribution, take advantage of it. In addition to receiving the company match, you get the added potential benefits of any tax-deferred growth and compounding returns.
Let's say, hypothetically, your company offers a match of 50¢ on every $1 you contribute, up to 3% of your salary. If you make $60,000 a year and contribute 3% or $1,800, and your company kicks in another $900, your annual contribution could add up to $2,700. Assuming a hypothetical compound annual growth rate of 7%, your savings could grow to more than $37,000 in ten years.
Contribute the maximum to your workplace savings plan.
Of course, saving just 3% a year is probably not enough to generate the savings you will need to retire, which could be hundreds of thousands of dollars or more for even basic expenses. So, try to contribute the maximum to your workplace savings plan each year. For 2013, the maximum is $17,500; $23,000 if you are age 50 or older.
Fidelity's rule of thumb suggests ramping up your savings to at least eight times your ending salary before retirement, if you can afford to. Of course, this is only a starting point. Your savings target may be different (see Viewpoints "How much do you need to retire?"). And you don't need to reach it overnight. For example, by age 35, Fidelity suggests that you should have saved 1X your current salary, then 3X by 45, 5X by 55.2
If you think your tax rate will be higher in retirement, consider opting for a Roth workplace savings plan, if your employer offers one. With a Roth, you contribute after-tax dollars, but any earnings and dividends grow tax free, and withdrawals are also tax free if taken in retirement (read Viewpoints "Nine compelling reasons to consider a Roth IRA"). Also, new legislation has made in-plan conversions easier.
Pay down high interest debt.
If you are paying more than 8% to 10% on credit card or other debt, use any extra savings to pay down the balance. If you have multiple accounts, you should work on the one with the highest interest rate first. Continue to make the minimum required payments on other debts (so you don't get hit with any penalties). When that first debt is paid off, move on to putting your extra money toward paying off the next.
As you pay off your debts, it should become easier to pay off the remaining debts, because you have lower interest payments and therefore more money to work with. Continue the process until you're out from under all your high interest debt. For debt you cannot pay off, consider consolidating it into a credit card or home-equity loan at whichever institution offers you the lowest rate, making sure the payment schedule matches your own goals and financial situation.
Contribute to an IRA.
Individual retirement accounts (IRAs) offer another tax-smart way to save for retirement. There are two basic options:
In general, we recommend opting for a Roth IRA if you think your income tax rate will be higher in retirement. To learn more about Roth IRAs, read Viewpoints "Nine compelling reasons to consider a Roth IRA." To determine whether a Roth is right for you, use our calculator.
If your employer offers a health savings account (HSA) along with a high-deductible health care plan, consider opening one. Our research shows that it can be a tax-efficient way to save and pay for both current and future qualified medical expenses, including those qualified medical expenses in retirement. Although your out-of-pocket health care costs may be higher depending on your health care needs, your premiums may be lower. Also, some companies contribute to employees' HSAs, and employee contributions are generally made pretax, which means your net after-tax costs can be lower. Contributions can also be made after tax. And what you don’t spend in your HSA in one year can be carried over from year to year to cover future qualified medical expenses, including those in retirement.
HSAs have a unique triple tax advantage3 that can make them a powerful savings vehicle for qualified medical expenses in current and future years: Contributions, earnings, and withdrawals are all free of federal income taxes. To make the most of your HSA (if you have access to one and you can afford it), consider paying for current-year qualified medical expenses out of pocket and letting the full HSA balance remain invested for future qualified medical expenses, including those in retirement. For 2013, individuals can contribute up to $3,250 to an HSA, and families up to $6,450. Plus, there is a $1,000 catch-up provision for those age 55 or older. In 2014, the contribution limits are going up to $3,300 for individuals and $6,550 for families.
Weigh deferring compensation.
If your company offers a nonqualified workplace savings plan and you have already explored other workplace options, and if your company offers a nonqualified deferred compensation plan—and you have the means—consider allocating some of your paycheck there as well. You can decide how much to defer each year from your salary, bonuses, or other forms of compensation.
But a deferred compensation plan is not for everyone—and the rules are complex—so you'll want to weigh the pros and cons carefully before signing up. To learn more, read Viewpoints "Nonqualified deferred compensation trilogy."
If you've taken advantage of your tax-advantaged workplace savings options and contributed to an IRA, but still want to save more, you might want to consider deferred variable annuities. Deferred variable annuities typically allow you to invest in funds that hold stocks and bonds—and any earnings grow tax deferred. Unlike some of the options mentioned above, there are no IRS limits on how much you can invest in an annuity.
To maximize your savings potential in an annuity, it is important to choose one that is low cost, as investments in annuities are subject to insurance charges in addition to fund charges. When you're ready to withdraw from an annuity, any earnings (in addition to any pre-tax contributions) are taxed at ordinary income tax rates (plus any Medicare surtax, state and local taxes). Also, keep in mind that any taxable amounts withdrawn before age 59½ may be subject to a 10% IRS penalty.
It's also important not to overlook saving for your other goals, such as college and graduate school. Among the best ways to save for a college goal is a 529 college savings plan, which is a tax-advantaged plan designed to pay for qualified higher education expenses, and a Coverdell Education Savings Plan. For both types of accounts, qualified distributions are federal income tax free. See the college savings tool below to explore saving for an education goal.
One last thought: To make it easier to stay on track with your savings goals, consider transferring some of your paycheck automatically to your chosen savings vehicles, be they workplace savings plans, HSAs, IRAs, annuities, or even taxable accounts. Then give yourself a pat on the back—you're a smart saver.