Previously, I had talked about the importance of saving early and retirement vehicles such as a 401K. However, I didn’t go into too much detail about how they work, why they are important, and how they can help you. According to a Vanguard study, the median 401K balance of someone from the ages of 25-34 is just over $9,000. For someone from the ages of 35-44, the median balance is just over $26,000. In my opinion, those are very abysmal amounts especially considering the benefits of using one of these vehicles. If more people understood the importance of a 401K and all the benefits they bring, I’m sure that they would make a greater effort to contribute more. If you don’t have access to a 401K account, don’t worry, there are other tax advantaged retirement accounts that I will mention later.
You may not think about it, but taxes eat away at your investment returns. Most people tend to focus on their rate of return without realizing that legally avoiding taxes through a tax-advantaged retirement vehicle can easily contribute to a 25%+ return depending on their tax bracket. If you have a large dividend portfolio, your dividend income would get taxed every year. Although your qualified dividends will get taxed at a lower rate, those taxes still add up over time. Thankfully, you can use a Roth IRA to avoid taxes on your investment earnings.
Once you start working, it is wise to start saving some of your money for retirement. One of the most popular investment vehicles is the Individual Retirement Account or IRA. It is a personal account that allows you to contribute your savings toward retirement. Regardless of what company you work for, the account is yours. Once you put money in that account, you can purchase a variety of investment vehicles such as stocks, bonds, exchange-traded funds, and mutual funds. For 2015, the IRS limits your contribution at $5,500 for the year. The contribution limit is increased every few years to keep up with inflation. If you can consistently contribute money to your IRA while investing it in high-quality stocks, you’ll position yourself well for retirement. Remember, one of the tried and true ways to build wealth is to save and invest for the long-run, and a tax-advantaged vehicle such as an IRA is a perfect way to do this. In fact, there is even a way to guarantee up to 50% return on your IRA.
For people in the lower income tax brackets and recent graduates who may not have worked the full year, there is a Retirement Savings Contribution Credit (Saver’s Credit) that you can take advantage of. Most investment professionals tend to focus on people with higher incomes, therefore they may overlook this obscure tax credit. This little known tax credit can provide you a substantial return on your investment before any market returns. See the chart below applicable to 2015.
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