Don’t let a low income prevent you from building a retirement nest egg
It's extremely difficult to save for retirement when your paychecks are barely big enough to cover your basic expenses. But there are a variety of strategies you can use to build a nest egg, even on a small income. Here's how to best prepare for retirement with a meager salary:
Find a job with good retirement benefits. When deciding where you would like to work, make sure you consider the retirement plan as part of the compensation package. "If they offer a retirement plan, that's a job that should probably be looked at a little harder than one that does not have a retirement plan," says Sam McPherson, a certified financial planner and CEO of McPherson Financial Advisors in Brooklyn, N.Y. "If you participate and you get a match, you are effectively getting a raise beyond what their quoted salary is." For example, if you are choosing between two positions that each pay $35,000 per year, but one offers a 401(k) match of up to 3 percent a year, you could potentially earn $36,050 at the job with the retirement account if you save enough to get the entire match, $1,050 more than the job without the 401(k) match.
Take advantage of tax breaks. If you save even a small amount in a traditional 401(k) or IRA, you can defer paying income tax on the amount contributed. "You reduce your taxable income by the amount of your contributions to a regular 401(k)," says Scott Winkler, a certified financial planner and founder of Winkler Financial Planning in Norcross, Ga. A worker in the 15 percent tax bracket who saves $1,000 in an IRA or 401(k) will save $150 on their next federal income tax bill. IRA, but not 401(k), contributions can even be made just before you file your tax return in April to capture nearly immediate tax savings.
Get the saver's credit. Low- and moderate-income workers who contribute to a 401(k) or IRA are additionally eligible for a retirement saver's tax credit. Employees who earn less than $29,500 for singles, $44,250 for heads of household and $59,000 for couples in 2013 may be able to claim this tax credit worth up to $1,000 for individuals and $2,000 for couples. "Your credit rate is dependent on how much you contribute and depends on the size of your income," Winkler says. The saver's credit can be claimed on up to $2,000 in retirement account contributions, and the credit ranges from 10 percent to 50 percent of the amount contributed, with the biggest credits going to savers with the lowest incomes. For example, a couple earning $30,000 that contributes $1,000 to a traditional IRA would get a $500 credit.
Consider a Roth IRA. Workers who are in a low tax bracket but expect to be in a higher tax bracket later in their career or in retirement have much to gain by making Roth IRA or Roth 401(k) contributions. Roth accounts allow you to pre-pay income tax based on your current low income. No income tax will be due on withdrawals in retirement, even if you are in a higher tax bracket then. "It's best to use a Roth when you are younger and you have a very long time for growth," Winkler says. Roth accounts also give you the ability to withdraw your contributions, but not the earnings, without having to pay income tax or a penalty if you need the money for an emergency. "The Roth has more flexibility," McPherson says. "With a Roth, you don't get any tax deduction, but if you had to withdraw your contributions, you don't have to pay any tax or any penalty."
Keep costs low. While it's important for all investors to make sure they aren't paying more in fees and investment expenses that they need to, fees can be especially problematic for retirement savers who need to make every dollar count. "It's enormously important to choose low-cost index funds," McPherson says. "The one thing investors can control is how much we pay for our investment management and investment accounts." Actively managed equity funds had an average expense ratio of 0.92 percent in 2012, far higher than the 0.13 percent average annual cost charged by index equity funds, according to Investment Company Institute and Lipper data.
Automate your retirement saving. It's often a good idea to have the money you plan to save for retirement withheld from your paycheck so that you are not tempted to spend it on something else. If payroll withholding is not an option at your job, consider setting up a direct deposit from your checking account to a savings or investment account that occurs immediately after you receive each paycheck. "Set up any sort of automatic transfer from your checking account to somewhere else that is not easily accessible," says Paul Sanchez, a certified financial planner for Sanchez and Zures in McLean, Va. "Once you turn it on, people tend to stick with it. Even something as simple as $10 a week over a period of time can add up pretty quickly."