There are dozens of excuses that people use for not saving for retirement. And they all sound good. In fact, you probably have a few of your own. Rather than add fuel to the fire, in this article, we'll give you four reasons why you should save for retirement.

Excuses Vs. Reasons

Excuses are just justification for not doing what we know we should be doing or should have done. Therefore, you should save for retirement because:

1. You don't want to rely on the welfare system to finance your retirement years.
2. You won't to have to live with your children just because can't afford to live on your own.
3. Saving in a tax-deferred retirement account reduces your income taxes.
4. Saving in a tax-deferred account produces a compound effect on your return on investment.

Sound good?

Then let's talk further about these four reasons.

The Big Four

1. You don't want to rely on the welfare system to finance your retirement years.
There's nothing wrong with using welfare (officially, Temporary Assistance to Needy Families) for aid if you have to. Many Americans have used it as a bridge to achieving their financial independence. And, it is your right to do so, especially when you have spent all of your working life paying into the system. The issue is, do you really want to be in the position where that is your only choice during your retirement years? How would that affect your retirement lifestyle? With the limitations that you would face with such limited financial resources, you run the risk of barely being able to afford the basic necessities. (To learn more, see Introduction To Social Security.)

2. You won't to have to live with your children just because you can't afford to live on your own.
If you have children, you probably wouldn't mind spending as much time with them as you possibly can. But – for the most part – you probably also want that to be at your discretion. Having to live with the kids because you don't have the financial resources to live on your own isn't how most people want to spend their retirement years, regardless of whether your children feel you are a welcomed responsibility or a burden they simply cannot afford. Being financially dependent not only means depending on someone else to cover your living expenses, but it may also mean giving up your freedom and your independence. (For related reading, see Retire In Style.)

Apart from winning the lottery or getting a big inheritance, the key way to ensure that you do not fall into the categories above is to make sure that you save enough to cover your expenses during your retirement years.

The vehicles in which you can save are broad and varied, but they all fall into two key categories;  tax-deferred and non-tax deferred; we will call the latter "regular savings." While saving is generally a good thing to do, the compound effect of saving in a tax-deferred account cannot be overstated because it:

  • reduces the amount of taxes you would owe on these amounts
  • allows you defer (or even avoid) the taxes you owe on the earnings that accrue on your investments
  • produces the effect of earnings-on-earnings, resulting in a compound effect not available in regular savings account

3. Saving in a tax-deferred account reduces your income taxes.
If you make deductible contributions to a traditional IRA, it reduces the income that you have left because you must take funds from your savings in order to make that contribution. If you make salary deferral contributions to a 401(k) plan on a pre-tax basis, this reduces the amount of take-home pay you receive. However, the net effect is less than the amounts you contribute to these plans because the amount by which your income is reduced is less than the amount you contribute. (For further reading, see IRA Contributions: Deductions And Tax Credits and How To Become A Millionaire.)

Let's look at some examples:

Example 1

  • Adam earns $50,000 per year.
  • His income tax rate is 25%.
  • He gets paid on a weekly basis.
  • He contributes 10% of his salary to his 401(k) account each pay period.
  • Adam's weekly contributions to his 401(k) will be $96.
  • His paycheck would be reduced by only $72.

Example 2

  • Betty earns $100,000 per year.
  • Her income tax rate is 28%.
  • She gets paid on a weekly basis.
  • She contributes 10% of her salary to her 401(k) account each pay period.
  • Betty's weekly contributions to her 401(k) will be $192.
  • Her paycheck would be reduced by only $138.

Additionally, these contributions reduce the amount of income taxes you pay.

Let's look at an another example. Assume you contribute $15,000 to your 401(k) account each year, which earns at a rate of return of 8%. Assume that your tax rate is 28% and you invest these contributions for a 20-year period. The estimated net results, compared with the effect of adding these amount to your regular savings accounts, would be as follows :

Number or Years = Retirement Age - Age [1] 20
Total Value if Taxed Annually [2] $568,732.24
Total Tax-Deferred Value [3] $741,343.82
Income Tax for 100% Surrender [4] $123,576.27
Total Tax-Deferred Value After-Tax [5] $617,767.55
[#
5-#2

] The Tax-Deferred Advantage [6]

 

 $49,035.31
 

By adding the amounts to your tax-deferred account instead of your regular savings account, you save $49,035.31 in taxes.

4. Saving in a tax-deferred account produces a compound effect on your return on investments.
If you add your savings to a regular savings account, the earnings that accrue on those amounts are taxed in the year those amounts are earned. This reduces the amount you have available to reinvest by the amount of taxes you must pay of these amounts.

Let's look another example.
Assume you invest $50,000 and it accrues earnings at a rate of 8%. This produces earnings of $4,000. If your tax rate is 28%, that amounts to $1,120 that is paid to the tax authorities, leaving $52,880 to reinvest. We can also go back to the example in No. 3, which not only shows that you would pay less taxes, but that the value of your investments after tax would be even greater as a result of the compound effect of tax-deferred growth:

  • Net $617,767.55 if you saved the amount in a tax-deferred account
  • Net $568,732.24 if you saved the amount in an after-tax account

These numbers are compelling and get even more so when the earnings period is longer and the amount saved greater.

The Bottom Line

The examples presented in this article demonstrate the compound effect of tax-deferred growth, which is the key selling point and attraction for IRAs and employer-sponsored plans. The results can be even more compelling if the savings vehicle is a Roth IRA, where earnings can be tax free. As such, if you are eligible for a Roth IRA or work for an employer that offers Roth 401(k)/403(b), careful consideration must be given to determine which is more suitable for your financial profile. The bottom line is, regardless of which type of retirement account suits your profile, compounding could be your ticket to a financially secure and independent retirement.