Reasons For Having An IRA or 401k

Did you know that the Social Security Administration’s trustee report stated that Social Security will begin to run a negative cash flow by the year 2017 and by the year 2036 will not be able to pay full benefits? With the impending Social Security crisis and dramatic reduction in pensions, it is imperative to begin planning for your financial future today.

Social security might not be enough to secure your financial future. That’s why the government created the different retirement savings plans, to help you save for your future. IRA and 401k investments grow tax free or tax deferred and compounds over time which maximizes your ability to grow wealth. There are many advantages to these plans and the advantages will depend in part on the plan itself.

IRA And 401k Plan Advantages include:

A. Compound Interest– Albert Einstein once said that “compound interest is the most powerful force on earth”. This is because compound interest occurs when you not only earn interest on your original investment sum, but also on the interest earned on the original sum.
Let’s look at a simple example of the power of compound interest. Let’s say at age 25 you decide to cut out your daily coffee routine at the local coffee shop saving you $4.50 a day. That would equate to a little over $136 per month. If you received 8% in compounding interest each year, you would have $25,533 after 10 years. So after 20 years, you’d receive $80,658 and after 40 years when you are age 65, you’d have an amazing $456,602.

B. Tax Deferred and Tax Free Profits – This great power of compound interest is increased dramatically in tax advantage accounts such as IRAs and 401ks since the tax free or tax deferred portion also grows each year. For example, if you were to contribute $5,000 a year to a tax advantaged account like an IRA or 401k and assume an 8% compound interest rate of return for 30 years, your bank account would be worth $561,416 at the end of year 30. If you made the same investment in a non-tax sheltered environment (a fully taxable account), assuming a 28% tax rate, it would be worth $373,985 instead of $561,416. This is a whopping difference of $187,431. As you can see, in the graph below, the effect of taxes on your savings can be dramatic.

C. Tax Deductions – Certain IRAs and 401ks allow you to reduce your taxable income today while saving for your future. For example, if you contributed $5,000 to a Traditional IRA this year, and if you meet qualified income levels, you are eligible for a $5,000 tax deduction when filing your tax return. In a 401k, you can deduct up to $17,000.

D. Protected from Creditors – IRAs and 401ks are afforded protection from bankruptcy through the Employee Retirement Income Securities Act (ERISA) under the US Department of Labor and thus generally are shielded from creditors in bankruptcy proceedings.

E. Wealth For Future Generations – Some types of government sponsored savings plans allow the passing of assets to beneficiaries after death while avoiding taxes. This benefits your family’s financial future by leaving valuable assets to your loved ones without the burden of taxes. This has been under some scrutiny recently since the government is trying to generate revenues in the current economic downturn.

Each government sponsored savings plan possesses unique tax advantages to maximize your future wealth and each has unique eligibility requirements. It is important that you figure out the right plan for you and start saving in order that you may enjoy the benefits of your retirement years.