Saving for retirement is important. The only way to effectively save for retirement is to do so slowly, a bit at a time, over a long period of time. There is no instant gratification here.
The upside to saving for retirement is that in reviewing your accounts every month, or every quarter, or every year, you will build a sense of security and peace of mind that you will have what you need when you need it.
It’s hard to put a price on that.
The truth is, saving for retirement – or for anything – is hard. Life is expensive. No matter how well any of us does financially, it’s easy to get caught up in thinking about what we don’t or can’t have.
But inflation and time will keep on moving forward whether we do or not, so it is in the best interest of each of us to develop a solid plan for saving for retirement.
Luckily, there are many ways to do this.
The government helps, by allowing for certain types of retirement accounts that allow you to save money on a tax-deferred basis. Taking advantage of these products can help you develop good saving habits as well as maximize your dollars to save as much as possible for retirement.
You’ve probably heard of one of these plans, called a 401(k). There is also a type of plan called a 403(b). The funky names are based on the section of United States tax code to which they refer. The tax code is notoriously long, detailed, and intense. In this post, our goal is to break down the basics of the 403(b) plan so you feel confident investing in it should it be offered by your employer.
Why not just use a savings account?
A savings account sounds like a wise choice for saving money, doesn’t it? After all, it has the word “savings” in its name. You should definitely have money in a savings account, though these types of accounts are best for shorter term needs, like an emergency fund, and to diversify your finances a bit.
An emergency fund is exactly what it sounds like: money that you have on hand available to use on a moment’s notice in case of an emergency. It’s like the financial version of a fire extinguisher stored behind glass. Think of it as having its own “in case of emergency, break glass” sign on it. The money is there to use if you need it, but it’s the most helpful if you don’t use it on a daily basis.
The upside to a savings account is that the money is readily available. The downside is that the money will earn very little interest while in that account. Savings accounts are not designed to help you grow your money. They are designed to serve as money storage. You earn a little bit of interest in exchange for letting the bank hold (and use) your funds, but interest rates typically do not keep up with inflation and are not really going to help your money grow.
Inflation is the amount that prices for goods and services changes year to year.
Typically, when the economy is strong, inflation rises about 2 percent per year. This means that things you want to buy will increase in price, on average, 2 percent per year. That’s why the cost of a gallon a milk 20 years ago was a very different number than the cost of a gallon of milk today. That’s also why it’s important to find investment products that will earn more 2 percent per year, so that you come out ahead in the long run.
Go take a look at how much interest your savings account is earning right now. See the problem? It’s less than 2 percent, right?
Experts are predicting that the average rate of return for investing in the stock market will hover around 3-5 percent over the next ten years. That’s lower than the historic 9.7 percent return, but still beats the rate of return on your savings account, probably by a lot.
How do you beat inflation?
The key to saving for retirement, as opposed to saving for an emergency fund or other short term need, is to look for ways to invest your money that are likely to gain more than the cost of inflation over time.
While there is always an element of risk to investing in the stock market, there are strategies to minimize that risk, and investing in your company’s retirement plan, often a 401(k) if you work for a for-profit, or a 403(B) if you work for a non-profit, is the best way to do this.
If you have a salaried position, as most physicians do, you likely have the option of participating in a retirement plan. These plans are only available through a participating employer. You can’t get the tax break on your own. (There are other ways to save for retirement, beat inflation, and even save money on your taxes without using an employer plan. Those are topics for different blogs, or give us a call anytime.)
To invest in a retirement plan that allows you to maximize your retirement dollars and participate in what is known as a tax shelter, you need access to a retirement plan through your employer. If your employer is a for-profit organization, chances are good that the retirement plan will be what is known as a 401(k). If, though, you work for a nonprofit employer, in particular a school, a church, some hospitals, or other organizations with nonprofit status, chances are good you will have the option to participate in a 403(b).
Some employers still offer pensions, but those are more akin to unicorns these days. You’ll likely never have the opportunity to participate in one of those.
Why the funny names?
Retirement plans start to sound a bit like alphabet soup sometimes. The funny names are simply references to the part of the U.S. tax code to which they refer.
So, what’s a 403b?
As mentioned above, a 403(b) is a retirement account that you may participate in through your employer by having pre-tax dollars taken out of your salary before you are paid. This way you are taxed on less money, and get to invest money in investment accounts selected by your employer where it can grow at a rate that hopefully exceeds inflation.
Often, employers will offer to match some or all of your contribution, as a way to increase your compensation package and remain competitive to talent.
A 403(b) account is designed specifically for nonprofit organizations because they are typically cheaper plans to manage than 401(k)s. This makes the administrative fees lower, which is an advantage for you.
So, what does it mean to save pre-tax dollars?
Say you get paid every 2 weeks. With a salaried position, you can set up certain benefits to be deducted from your salary before Uncle Sam takes his cut.
Think of it this way: If I hand you $100 in cash, and then at tax time in April, you have to pay 20 percent of that $100, which is $20. You keep $80.
But, if I pay you that $100 as salary, you get a paycheck. You can authorize me, as your employer, to move $10 a paycheck, for example, into a retirement account such as a 403(b).
That leaves $90 left to be taxed by Uncle Sam.
20 percent of $90 is $18. So, you pay $18 in taxes, instead of $20. You pay less taxes, and keep more of your own hard-earned money.
Now, think about how much bigger your paycheck is than $100 and realize that these percentages add up.
What if I can’t afford to save for retirement?
We hear all the time that people feel like they can’t possibly afford to save for retirement right now. They owe too much in debt, the cost of living is too high, and they really want to just live a little, already.
But here’s the important thing: if you sign up to put money into a retirement plan out of your paycheck before your salary is taxed, you will save money in the long run.
Sure, your actual take home pay feels smaller in the short term because that money for retirement goes right to the retirement account and bypasses your wallet.
But if you look at saving for retirement and tackling debt as a long-term habit instead of a short-term inconvenience, you will see that taking advantage of saving for retirement on a pretax basis through a company retirement plan such as a 403(b) means you will have more money of your own to keep in the long run.
You will get to keep more of your own money and you will build a nest egg to support your retirement.
So I never have to pay taxes on this money?
Of course you do. But, a tax shelter doesn’t mean you never pay tax on the money. It means you don’t pay tax on the money right now.
You’ll pay the taxes much later, when you withdraw the money from the account, once you’re retired. Because you’ll be retired, your annual income will be drastically reduced, so you’ll be taxed at a lower rate than you would be today, once again saving money.
Are there limits to how much I can invest?
For 2019, if you’re under age 50, you can contribute up to $18,500 per year.
If you are over 50 years old, you can play catch-up by investing an additional $6,000 per year, for a total of $24,500.
Keep in mind, the U.S. tax code can and does change year over year.
One of the best benefits of participating in a 403(b) is that you can take advantage of your employer matching some or all of your contribution.
If they do, take them up on it, always. To not take the match is to leave money on the table. It’s like saying you don’t actually want part of your compensation.
We know that it’s tempting to not take the match, because to get it, you have to let part of your salary disappear from your paycheck before you even get your paycheck. When money is tight, and debt looms large, this can feel impossible.
Do it anyway.
Say you earn $50,000 per year. Your employer says they will give you fifty cents for every dollar you contribute up to a maximum of 5 percent.
So you put 5 percent of your income ($2,500) into the 403(b). Your employer will put half of that (fifty cents from them for every dollar from you) into your retirement account as well, which is another $1,250.
Every year, spread out over 26 pay biweekly paychecks, you put $2,500 from your salary into the account, and your employer puts another $1,250 on top of your salary into the account.
That means you earn $50,000 plus another $1,250 over the course of the year for total compensation of $51,250. If you don’t put 5 percent into the retirement account, you forfeit that $1,250.
Would you really turn down an extra $1,250 a year? That’s an extra hundred bucks a month, more or less, earning money in your investment account.
As an added bonus, that $3,750 you and your employer are collectively investing in your 403(b) account is growing at a rate that is likely beating inflation, thanks to the stock market.
Where does the money go?
Your employer likely is working with a particular investment house, like Vanguard or TIAA-CREF. Within that organization, there will be a whole list of mutual funds available.
Some companies choose mutual funds for you as to how the money will be invested. Some let you choose. But the short answer to this question is that your money will be invested in mutual funds, which means it will be spread out so you own little bits of lots of bigger companies. This is a good way to take advantage of the returns of the stock market without a huge risk.
Tell me again why I want to participate in a 403(b)?
- You don’t pay tax (for now) on your contributions
- You don’t pay tax (for now) on the money you earn as your investment grows (so, no penalty for earning interest, in a sense)
- You may be eligible for a tax credit (see your accountant about this one)
- You get more money in your paycheck in the long run
- It may increase your overall compensation if your employer offers a match
- There is potential to earn more than if you kept your money in a traditional savings account
- 403(b) accounts are professionally managed so you don’t have to know how to invest in the stock market to take full advantage of investing in the stock market
Dollar cost averaging
Participating in a 403(b) plan allows you to maximize a beautiful thing called dollar cost averaging.
This is important because while investing in the stock market is generally a good long-term idea, the stock market ebbs and flows. It is only certain in its uncertainty.
Because one can’t really predict how the market will behave, there will be times when you lose money. But, that just means that when the market goes back up, and it will, all of those shares of stock that you hold are a bargain.
You can take money out of your account, known as distributions, without penalty starting when you are 59.5 years old. Taking money out sooner means paying a penalty of 10 percent.
That penalty is an incentive to keep your money invested for the long run. That boosts the economy (which is why the government allows these types of pre-tax plans to begin with) and also helps keep your spending in check.
You can essentially borrow some of your own money without tax consequences as long as you pay it back within 5 years, but we do not recommend doing that. It’s better to adopt the saving mindset and let your money grow and work for you.
How to get started
We get asked a lot about how to get started with saving for retirement, especially when there seemingly isn’t any money available to save.
While the rule of thumb is to save until it hurts and then save some more, if you want to put a number on it, aim for saving 15 percent of your income every year. More is always better.
But, we’re realists and know this is not always possible or comfortable for everyone. So, if you do nothing else to save for retirement, make sure you get the full match available from your employer.
Some companies offer fifty cents on the dollar up to 2 or 3 or 5 percent, some match dollar for dollar for a certain amount. Others might do a combination of this, matching dollar for dollar for the first 2 percent and then fifty cents on the dollar for the next 3 percent. Whatever it is that your company will match, get it.
You will not regret this.
To do otherwise is to essentially tell your employer that you don’t actually want your whole paycheck. It’s the same as leaving money on the table.
Remember, putting this money aside pre-tax increases the amount of post-tax money you get to keep. Taking advantage of your company retirement plan allows you to create good long-term saving habits and get some good tax advantages.
The best part is that it’s easy. Simply sign up. If putting aside 15 percent seems insurmountable, then start with whatever amount gets you the full match. Then, every time you get a raise, increase the amount by 1 percent. You will still get to enjoy a raise in your paycheck, and your retirement account will enjoy a raise as well. This is a win all the way around.
Learn something new? Let someone else know! Check out the podcast on iTunes to share!