Chapter 69: Retirement Savings

J. Zachary Klingensmith

Chapter 69: Retirement Savings

J. Zachary Klingensmith

Learning Objectives

Describe and employ different money market accounts to meet personal saving goals.
Define income tax and describe helpful tax planning strategies.
Recognize the benefits and options of retirement planning at an early age.

Why Should You Save Money?

In short, it allows you to enjoy greater security in your life. In this chapter, we will take a look at savings. Why save? When to save? How to save? These are all critical questions, especially if you want to be financially secure in retirement.

Death and taxes are two certainties in life. While we cannot avoid death, we can take steps to minimize our tax liability. In this learning unit, we will also discuss the basics of taxes, how to determine your tax liabilities, and how to reduce, eliminate, or defer your income taxes legally.

In the previous chapter, we talked about developing a budget. When you have a budget surplus, you gain some flexibility with your funds. You can increase your spending, savings, or investment. In this chapter, we will look at savings in more depth, focusing on retirement savings.

Retirement is when you stop selling your labor, and your primary source of income changes from earned income to retirement benefits, personal savings and investments, and Social Security. It is never too early to start planning for retirement so that you can enjoy your golden years without financial worry.

Five Benefits of Savings

It helps in emergencies (e.g., car repair expenses).
It cushions against sudden job loss.
It helps finance big-ticket purchases (e.g., a new car or a first house) and major life events (e.g., going to college or starting a family).
It limits the amount of debt incurred.
It helps prepare for retirement.

What Should You Save For?

A rainy day

It is used to pay for unexpected expenses.
Ask yourself: If your income disappeared, what essential bills and obligations would you still have to meet?
To have a fully funded emergency fund, you must save enough to cover 3 to 6 months of those expenses.
The fund needs to be accessible immediately on demand.

Planning irregular expenses

Annual membership: Sam’s Club ($50)
Semiannual expense: Auto insurance premium ($300/semiannual)
Your car tires are beginning to wear thin; replacement cost is unavoidable in the near future.
Strategy: Divide the cost and save part of the total each month. (e.g., Save $50 each month for auto insurance premiums.)

Planned large expenses

Example: You want to work on home repairs or buy a new leather sofa.
Strategy: Estimate the expense, and save part of the total each month until you can pay in full.

Retirement

401(k) or 403 (k)
Traditional IRA, Roth IRA

Savings Rate

The savings rate measures savings over the period in comparison to disposable income.

Savings Rate Formula

For any given period of time:

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$\frac{Savings}{Disposable income} \times 100 %$ “> $\frac{Savings}{Disposable income} \times 100 %$

Savings Instruments

There are many different ways to save your money until you use it. The primary difference is the level of liquidity. Liquidity refers to how easy it is to turn an asset into cash without losing value.^[2]

Liquid Asset Examples

Cash (on hand) and cash equivalents
- Cash equivalents: Low-risk, near-cash items that can quickly be converted into cash (e.g., checking account and savings account)
Securities: CDs, MMMFs, bonds, stocks

Non-liquid Asset Examples

Real estate
Vehicles
Jewelry
Collections of valuable items

Table 69.1: Comparison of Savings Instruments

Source: “ Personal Finance, Chapter 7” by Saylor Academy | CC BY-NC-SA 4.0
	Low	High
Liquidity	CDs	Checking, Savings, MMMFs
Risk Level	Checking, Savings, CDs	MMMFs
Interest Earned	Checking, Savings	MMMFs, CDs

When Should You Start Saving Money?

The answer is now! The earlier you start saving, the more quickly your money can grow.

How does your money earn money over time?

Money earns money through the magic of compounding. Compounding is the process of earning interest on interest. Watch the video [1:27] to learn more.

Why Pay Taxes?

Taxes are mandatory contributions levied on individuals or corporations by a government entity—whether local, regional, or national. Taxes provide revenue for governments to fund essential services—national defense, highways, police, a justice system—that benefit all citizens. Taxes also fund programs and services that benefit only certain citizens, such as Medicare, job training, schools, and parks.

Types of Taxes

To learn more, view the article, Types of Taxes.

Income Taxes

Most individuals pay federal, state, and local income taxes.

Federal Taxes

The Internal Revenue Service (IRS) administers the federal tax system. The tax year for federal income tax ends on Dec. 31. If you earn income, you must file a Form 1040, 1040A, or 1040EZ to determine your tax liability by April 15 of each year.

Additional information on federal taxes is available by viewing these resources.

To learn more about IRS 1040 form, view What Is an IRS 1040 Form?
To learn how to file your 1040 form, visit the IRS webpage, How to File
To estimate your tax liability and tax refund, if applicable, visit TurboTax
Watch this video from the IRS on How to Pay Your Taxes [1:51 minutes]

States Taxes

As of 2022, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming are the only states that do not have a state individual income tax.

Local Taxes

About a third of all states allow their counties, municipalities, and other local jurisdictions to impose an income tax. Tax rates are often lower than at the federal or state levels.

As of 2022, states with local income taxes are Alabama, Colorado, Delaware, Indiana, Iowa, Kansas, Kentucky, Maryland, Michigan, Missouri, New Jersey, New York, Ohio, Oregon, Pennsylvania, and West Virginia.

Tax Liability

Progressive Tax

Income tax is usually a progressive tax. The higher the taxable income, the greater the tax rate. Those income categories are called tax brackets.

There are seven federal income tax brackets for the 2023-2024 season: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your filing status (single, married filing separately, married filing jointly, etc.) and taxable income determine your bracket.

Table 69.2: Income Tax Brackets in 2023 (Single Filing Status)

Source: “ IRS Provides Tax Inflation Adjustments For Tax Year 2023 by Internal Revenue Service | Public Domain
If taxable income is	The tax due is
Not over $11,000	10% of taxable income
Over $11,000 but not over $44,725	$1,100 plus 12% of the excess over $11,000
Over $44,725 but not over $95,375	$5,147 plus 22% of the excess over $44,725
Over $95,375 but not over $182,100	$16,290 plus 24% of the excess over $95,375
Over $182,100 but not over $231,250	$37,104 plus 32% of the excess over $182,100
Over $231,250 but not over $578,250	$52,832 plus 35% of the excess over $231,250
Over $578,125	$174,238 plus 37% of the excess over $578,125

Determine Your Preliminary Tax Liability

Determine filing status (i.e., single, married filing separately, married filing jointly, etc.)
Refer to the appropriate tax brackets and find your tax on base and tax rate.
Apply the formula: Preliminary tax liability = Tax on base + Tax rate on excess × (Taxable income − Base)

Example—Determine Mohammed’s Preliminary Tax Liability

Mohammed’s filing status = Single and his taxable income = $31,000.
Using the table above, his taxable income falls into the second tax bracket: tax on base = $1,100 and tax rate on excess = 12%
Preliminary tax liability = $1,100 plus 12% of the excess over $11,000

$1,100 + 12% × ($31,000−$11,000) =

$1,100 + $2,400 = $3,500

Mohammed’s tax liability: he owes $3,500 in taxes

Income Tax Planning

There is no obligation to pay any more in taxes than legally required. Tax planning seeks legal ways to reduce, eliminate, or defer income taxes. To achieve this goal, you can 1) reduce taxable income, 2) apply for tax credit, or combine these two.

Reducing Taxable Income

Your income tax is calculated based on your taxable income. Reducing your taxable income, not your total income, is the key to paying less income tax.

We must differentiate between total income, gross income, adjusted gross income, and taxable income.

inverted pyramid showing total income at the top and taxable income at the bottom after subtracting taxes, adjustments and deductions.

Deductions

Deductions: Standard deduction and itemized deduction. The IRS adjusts the standard deduction for inflation for each tax year.

Table 69.3: Standard Deduction Amounts for 2023 Taxes

Source: “IRS Provides Tax Inflation Adjustments For Tax Year 2023” by Internal Revenue Service | Public Domain
Filing Status	Standard Deduction 2023
Single; Married Filing Separately	$13,850
Married Filing Jointly & Surviving Spouses	$27,700
Head of Household	$20,800

The standard deduction is the simplest way to reduce your taxable income on your tax return. You simply claim a flat dollar amount determined by the IRS.

Here is what that means: If you earned $75,000 in 2023 and file as a single taxpayer, taking the standard deduction of $13,850 will reduce your taxable income to $61,150. Use the itemized deduction only when it is greater than the standard deduction.

Exemptions

Personal exemptions are based on the number of people supported by the taxpayer’s income—one exemption each for the taxpayer, the spouse, and each dependent child. In 2017, for example, the exemption was $4,050 per person in the household. Personal exemptions have been eliminated beginning after December 31, 2017, and before January 1, 2026.^[11]

Reduce Your Preliminary Tax Liability

Final tax liability = Preliminary tax liability − Tax credits

Examples of tax credits are:

Health insurance premium tax credit
Hope scholarship credit
Section 529 college saving plan
Child tax credit
Retirement savings contribution credit
Mortgage interest credit

Strategies To Reduce Income Taxes

Reduce taxable income through your employer.

Premium health insurance plan
Transportation reimbursement plan
Flexible Spending Account (FSA)
401(k) retirement plan—Contribute to your employer-sponsored 401(k) plan at least up to the employer’s matching contribution amount.

Make tax-sheltered investments.

A tax shelter is a place to legally store assets so that current tax liabilities are minimized. A tax shelter may permanently reduce the tax amount or simply defer the taxes owed to a future period. Returns of tax-sheltered investments are tax-advantaged.

Examples of tax-sheltered investments:

Traditional IRA
Section 529 college saving plan
Government savings bonds
Capital gains on housing

How Tax Planning Fits Within Your Financial Plan

Ask yourself the following questions:

What tax savings are currently available to me?
How can I increase my tax savings in the future?
Should I increase or decrease the amount of my withholding?
What records should I keep?

Table 69.4: Financial Plan Example

Tax liability (based on applying tax rates to the taxable income)	$3,693.75	$2,868.75
Category	Current Situation	Long-Term Plan
Gross Income	$38,000	$38,000
− IRA Contribution	$0	$5,000
= Adjusted Gross Income	$38,000	$33,000
− Deductions	$6,300	$6,800
− Exemptions	$4,000	$4,000
= Taxable income	$27,700	$22,200

Then revise your financial plan.

Approximate Total Tax Savings = $825.00 per year

Why Should You Start Saving for Retirement Early? To Reduce or Defer Income Tax

We’ll look at two options to reduce or defer income tax: employer-sponsored retirement plans and individual retirement accounts (IRAs).

Employer-Sponsored Retirement Plans

Examples of employer-sponsored retirement plans that we’ll explore include:

401(k) plan:
- Traditional 401(k)
- Roth 401(k)
403(b) plan
Simplified Employee Plan (SEP)
Savings Incentive Match Plan for Employees(SIMPLE) Plan
457 plan. Visit 457 Plan to learn more.

Retirement Plans for the Self-Employed

Examples of retirement plans for the self-employed that we’ll explore include:

Keogh Plan: contribution from pre-tax income. To learn more about the Keogh Plan, read Keogh Plan: Definition Types, Advantages & Disadvantages .
Individual Retirement Account (IRA)
Traditional IRA
Roth IRA
Simplified Employee Plan (SEP) IRA. To learn more about the SEP, read Simplified Employee Pension (SEP) IRA: What It Is, How It Works

How Much Do You Need To Retire?

Watch How Much Do I Need to Retire? Retirement Planning 101 [5:08] for some valuable insight on this topic.

Key Takeaways

Project your taxable income and total withholding for this year.
Sign up for tax-advantaged employee benefits at your workplace.
You are never too young to start saving money.
Save for emergency fund first: Start with a $1,000 goal and save until you have a fully funded emergency fund to cover 3–6 months of essential expenses.
The higher the number of compounding periods, the greater the amount of compound interest.
Depending on your income, you can contribute to your employer-sponsored retirement plan and an IRA.

Licenses and Attributions:

Original content: CC BY NC SA:

This chapter contains content from the following sources in the text and learning activities:

(1) Personal Finance was adapted by Saylor Academy under a CC BY-NC-SA 3.0 without attribution as requested by the work’s original creator or licensor.

(2) “ The Math of Money ” by J. Zachary Klingensmith, OER Commons, is licensed under CC BY-NC-SA 4.0

Financial Literacy – 3 Making Your Savings Decisions. Access for free at: https://fscj.pressbooks.pub/financialliteracy/chapter/making-your-savings-decisions/

Modifications: Some content removed for brevity, consistency, and formatting purposes.