When people are young, saving for retirement is often the last thing on their minds. But starting young and saving every month can translate into a huge difference in your net worth at retirement — all through the power of compounding.
It’s a simple concept: Compounding allows savers to earn profit on their profit, or interest on their interest. Over an extended period of time, they can earn far more than they probably thought possible, particularly if the annual rate of return is eight percent or more. Even better, they can minimize taxes along the way.
To illustrate the power of compounding, take a dollar bill and invest it at a 10 percent rate of return. Every year, you earn 10 cents and at the end of ten years you’ve doubled your investment to $2 — and that’s without any compounding.
With compounding, in the second year, the 10 percent rate of return is added to your $1.10, and so on every year until at the end of those 10 years you wind up with $2.59. Compounding has increased the value of your investment by about 30 percent. Start multiplying that with larger amounts over even longer periods of time and you can see why it’s important to start saving early.
There are four critical factors that affect how much retirement plan contributors can accumulate before retirement:
1. When they start saving (the earlier, the better)
2. How much they save (the more, the better)
3. The rate of return (the higher, the better)
4. How much they pay in taxes (less is obviously better).
Focusing on the first factor, let’s say an employee contributes $3,000 a year to a tax-deferred qualified retirement plan account. Depending on when he or she starts saving and assuming an eight percent annual return, here’s the total at age 60:
Double all those totals if a contributor is married and his or her spouse follows the same drill.
To further understand the significance of starting early, let’s take a look at what a difference just five years can make. Comparing the $516,950 you accumulate from age 25 to the $339,850 saved by waiting until age 30, you can see that the difference is a whopping $177,100. Yet only $15,000 of that difference comes from additional contributions ($3,000 a year times five years equals $15,000). The remaining $162,100 is generated mostly by the power of compounding. That is, the interest on the interest.
Now, take a look at what happens when a saver contributes a total of $140,000 to a tax deferred retirement account earning eight percent a year, where the only difference is the age when he or she starts saving:
The Best Strategy: Encourage your employees to get an early start. How soon they begin saving is just as significant, if not more so, than how much they put aside. Invest early and often.
If your business is essentially a one-person operation, there’s an option to help you save more money for retirement: The Solo 401(k) plan.
Ordinarily, traditional defined contribution retirement plans allow annual contributions that are limited to either 25% of salary if you’re employed by your own S or C corporation or 20% of self-employment income if you operate as a sole proprietor or single member LLC. Also, traditional profit sharing plans, Keoghs or SEP plans are subject to a $54,000 cap on contributions to your account for 2017 (up from $53,000 in 2016).
Not bad, but with a Solo 401(k) plan, you can probably make substantially larger contributions that lower your tax bill and generate more tax-deferred earnings for retirement.
A Solo 401(k) is made up of two separate parts. Together, the two parts make the plan advantageous:
- Elective deferral contribution – As much as 100% of the first $18,000 of your 2017 salary or self-employment income can be put into an account. That amount increases to $24,000 if you are 50-years-old or older at year end (figures unchanged from 2016).
- Additional employer contribution – Your employer (your company or you personally, if you are self employed) can contribute an additional 25% of your salary or 20% of your self-employment income.
The sum of the two parts is capped at 100% of your annual employee compensation or self-employment income, or $54,000 in 2017, whichever is smaller. However, the dollar cap is increased to $60,000 for people age 50 or older (up from $59,000 from 2016).
A Solo 401(k) doesn’t force you to contribute more than you can comfortably afford: The plan lets you rack up major tax savings in good years, by making maximum contributions, but gives you the option of contributing less — or even nothing — in lean years when you need to conserve cash.
Plus, you generally get the benefits of traditional 401(k) plans, such as the ability to borrow from your account.
Establishing and operating any 401(k) plan means some up-front paperwork and ongoing administrative effort. With a solo 401(k), however, the administrative work is simplified since you are the only participant.
There are a couple of caveats:
- If you earn a very high income and are younger than 50, the Solo 401(k) may not permit larger contributions than a traditional plan because of the dollar cap on annual contributions $54,000 for 2017. In general, you should only set one up if it allows significantly larger contributions because a Solo 401(k) costs more to operate (up from $53,000 for 2016).
- If you have employees, you may also have to contribute to their accounts. In this case, you have a regular 401(k) plan that is subject to some complex rules.
Ask your employee benefits adviser to sort out the complexities of various retirement plans and determine whether a Solo 401(k) is right for you.
Annual Dollar Limits – Based on IRS cost of living adjustments, the Internal Revenue Code (IRC) limits for 2017 are as follows: