Top Ways to Save for Your Retirement in Your Twenties and Thirties

Part Two: How to save for retirement outside of an employer-sponsored plan 
To read part one, click here.

Despite various financial priorities competing for your attention in your twenties and thirties, you’re in an optimal position at this age to begin building a strong foundation for your long-term financial well-being and future security.  When time is on your side, the powerful effect of compounding returns enables your money to grow at an accelerated rate. As review, compounding refers to the process in which an asset’s earnings (capital gains or interest) are reinvested to generate returns from your initial principal as well as accumulated earnings from previous periods. 

If you’re self-employed or your workplace doesn’t offer an employer-sponsored retirement plan and you’ve yet to begin socking away funds for retirement, there’s no better time than the present to get started. For many twenty- or thirty-somethings in this position, the go-to financial tool that allows them to grow their retirement fund in a tax-efficient manner is an individual retirement account (IRA). 

However, you needn’t be self-employed or lack access to a workplace retirement plan to benefit from an IRA. There may be valid reasons to consider one even if you have a defined-benefit plan such as a pension, or if your employer offers a qualified retirement plan in your compensation package. 

In part one of our two-part series, we focused on how employer-sponsored benefits can help you to maximize your retirement savings. Here, we’re delving into the benefits of individual retirement accounts (IRAs), and effective strategies for building your long-term savings outside of a workplace retirement plan.

What an IRA is and how it can help you reach your long-range financial goals. 

An individual retirement account (IRA) is a long-term savings and investment account with significant tax benefits. Unlike a qualified-retirement account available through an employer, anyone with earned income or their spouse can use an IRA to save for their future. Crucially, the tax benefits of an IRA can enable you to acquire greater wealth in your retirement years than a standard savings or brokerage account would allow you to build.

If you’re self-employed or don’t have access to an employer-sponsored retirement fund, an IRA may be the primary instrument you use to grow your retirement savings on a tax-advantaged basis. But those who have an employer-sponsored plan may also contribute to an IRA, and in certain situations, may decide to contribute to an IRA instead of their employer’s plan. 

How a traditional IRA differs from a Roth IRA:

Many financial institutions like credit unions, banks, and brokerage firms offer both traditional and Roth IRAs. One major distinction between these two products relates to how they are taxed. Traditional IRAs offer tax-deferred growth on earnings, and potential tax deductions, while Roth IRAs allow you to make tax-free withdrawals in retirement.

The tax benefits of a traditional IRA versus a Roth IRA:

Both traditional and Roth IRAs offer tax benefits, but they differ in terms of how and when taxes are applied. With a traditional IRA, you don’t pay taxes on contributions and any potential earnings until you make withdrawals in retirement, at which time your distributions are taxed as ordinary income. In addition, if your contributions to a traditional IRA are eligible for a tax deduction, they can reduce your taxable income in the year they are made. But as the IRS explains, the deduction may be limited if you or your spouse has access to a retirement plan at work and your income exceeds a certain threshold.

On the other hand, your contributions to a Roth IRA are made with after-tax dollars. However, your earnings grow tax-free in a Roth account, and your distributions in retirement are tax-free. But it’s important to note that you won’t receive the immediate benefit of a tax deduction in the year that you contribute to a Roth account. 

How traditional and Roth IRAs compare with respect to the rules for withdrawals:

Another important distinction between a Roth and traditional IRA is that the Roth version offers greater flexibility with respect to access to funds. You can withdraw the original contributions (deposits you make) from a Roth IRA at any time without getting hit with taxes (you’ve already paid them) or having to pay an early withdrawal penalty. 

Before you’ve held a Roth account for five years, you can also avoid the 10% penalty for early withdrawals of your earnings if the funds are used for certain purposes, including but not limited to:  qualified educational expenses, the costs of childbirth or adoption (up to $5,000), and unreimbursed medical expenses exceeding 7.5% of your adjusted gross income.  And once you’ve held a Roth account for five years, the rules get more lenient. Having met the five-year holding requirement, both contributions and earnings can be withdrawn penalty-and tax-free for qualified distributions, such as the first-time purchase of a home (up to a $10,000 cap), a disability, a payment to a beneficiary after death, or if you’re at least 59 and ½ years of age.

When it comes to a traditional IRA, the rules regarding access to your funds are decidedly more stringent. In general, you’ll incur a 10% early withdrawal penalty and trigger income taxes on the distributed amount if you withdraw funds from the account before age 59 ½. Unlike a Roth, a traditional IRA doesn’t allow you to tap the money you contributed to the fund whenever you like. However, there are certain exceptions that may allow you to avoid the 10% tax penalty when taking early distributions. But you’ll have to pay regular income taxes on traditional IRA distributions regardless of when you take them. 

Traditional IRAs have required minimum distributions (RMDs) at retirement age:

In addition to fewer restrictions for early distributions, a Roth option can also provide you with more control over your individual tax liability in retirement. With a traditional IRA, you must begin taking annual required minimum distributions (RMDs) once you reach a certain age (73 in 2024). 

How much can you contribute to a traditional and/or Roth IRA?

For twenty and thirty-somethings, the maximum you can contribute to all IRAs (both traditional and Roth) is $7,000 in in 2024. Also, be aware that the IRS imposes income and filing status restrictions that determine whether (and how much) you’re eligible to contribute to a Roth IRA. And if you have a high income and you or a spouse has access to a workplace retirement plan, your tax deductions for contributions to a traditional IRA may be limited.

Starting now will enable you to harness the power of compounding returns — and watch your earnings grow exponentially.

The earlier you start saving and investing in a tax-advantaged retirement fund, the more time your earnings will have to compound and grow to build your nest egg and protect your spending power from inflation. On the other hand, it’s certainly understandable if other financial goals are demanding your attention in your twenties and thirties, and you haven’t yet reached the point where you are maxing out contributions to retirement funds. What’s most important is that you get started as soon as possible, even if you’re contributing a relatively small percentage of your income. Essentially, by starting early, you can invest less money but have more at retirement than if you had started later in life but contributed more. 

To set yourself on a course for success, be sure to automatic savings to a tax-advantaged retirement instrument once you’ve opened your account, whether by setting up recurring transfers from your checking account or by using direct deposit to divide your paycheck so that a portion of it goes directly into this fund. 

Finally, once you’re ready to start building a more secure financial future by opening an IRA, your credit union is here to help. The Police Credit Union provides both traditional and Roth IRAs with flexible savings options depending on your goals. Visit our site here to connect with our Virtual Branch. You can choose to schedule an appointment or meet a member of our team right away from your computer or mobile device.

The Police Credit Union does not provide Tax, Legal or Accounting advice. Members should seek their own professional counsel in these matters.

 

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