Tax Cuts Let You Boost Retirement Savings

TaxesYou’ll have more money in every paycheck next year as part of the year-end tax deal. Don’t spend it! That was money that should have gone to Social Security, but everyone knows that’s a fiction.

So instead of spending that 2 percent windfall — redirect it into your 401(k) or 403(b) plan at work — or into an Individual Retirement Account. Let’s see what that could turn into over the next 30 years of your work life.

Social Security was scheduled to take a 7.65 percent bite out of income up to $106,800. But the actual Social Security percentage (without the Medicare tax) was 6.2 percent. Now, under the new tax bill, that will be reduced to only a 4.2 percent deduction for 2010.

So with the help of the Tax Institute at H&R Block, let’s see what could happen to the tax cut money if you invest it instead of spending it!

Consider what happens to Susan, who has a salary of $65,000, and to Jessica, who has a salary of $125,000. Each is in line to see more money in her paycheck.

The FICA “savings” will be $1,300 for Susan, and $2,136 for Jessica. (Remember, FICA stops at $106,800 — so the “savings” stops at that point.) That’s how much more money they’ll see in their paychecks this year.

It’s tempting to use that money in any number of ways. But wait. You’re used to seeing that money deducted from your paycheck. Maybe you should redirect it to your retirement plan.

Here’s what happens if each woman invests the money in the company 40l(k) plan, where each gets a 50 percent match from her employer. That means more money is going to work for each of them.

And let’s say that the retirement account grows and compounds at the Ibbotson historic (75 year) average rate of growth for large-company American stocks (with dividends reinvested) of 9.8 percent annually.

Susan’s FICA savings for this year could be worth $32,218 at retirement in 30 years!

Jessica’s FICA savings for this year would be worth $52,937 in 30 years.

That’s all possible because they exercised a little discipline right now — and told the HR department to take the entire 2 percent FICA savings and redirect it to the retirement plan.

By the way, if they didn’t have a company retirement plan with a 50 percent match, but instead opened an Individual Retirement Account, Susan’s savings would be worth $21,479 — and Jessica’s account would be worth $35,292, even without the employer’s matching contribution. That’s still a significant amount of retirement savings.

(Hint: Fidelity will let you open an IRA in any of their funds with only $200 to start, if you agree to an automatic additional contribution of $200 every month. Call 800-FIDELITY to get started!)

And one more point, just so you see the possibilities.

What if Susan and Jessica became so hooked on saving that they continued making the same investment every year for the next 30 years — even though the FICA cut disappeared next year?

Susan puts away $1,300 every year and receives the employer match. Jessica continues to put away $2,136 every year, and continues to receive the match.

Of course, the first years of contributions had a lot more time to grow than the later contributions as they near the 30-year mark until retirement. But compound growth is a very powerful factor.

If Susan and Jessica each stick with their plan over 30 years, contributing annually and earning the market’s historic average annual returns:

Susan’s account would be worth $339,130.

Jessica’s account would be worth $557,217.

And to think it all started with a 2 percent cut in FICA!

Yes, I know the FICA cut is meant to be a stimulus for the economy. But it can also be a stimulus for your personal retirement plan.

By the way, you remember what the initials FICA stand for? It’s Federal Insurance Contributions Act. When they deduct FICA from your paycheck, you’re making a “contribution” to a plan that is unlikely to give you much real return on your money if it all.

So why not take the opportunity to make a contribution to a true retirement plan — an investment in your future and the future of America’s economy? That should give you a real return on investment.