Contribute to 401ks and IRA’s

If you don’t need the cash immediately, a great way to save money is by contributing to a retirement account. Every year, you can contribute a certain amount (limit this year is 18k), to your employer 401k, pretax. What this does is it lowers your taxable income for the year.

For example, let’s say you make 50k a year. Assuming you don’t put any amount in pretax accounts, your total taxable income will be 50k, making your federal tax liability about $5700, an effective tax rate of 11.44%. Let’s go to the other extreme, and say you put away $15000 that year pretax into your 401k. So that makes your taxable income 50000 – 15000 = 35000. Your federal tax liability is now about $3200, or about 9.2%. You basically saved yourself about $2500 that year! Now, you will eventually have to pay tax when you take money out of that account, and assuming you don’t want to pay any penalties you will need to wait until retirement. But that money can grow in that investment account, tax free until you withdraw.

If you’ve maxed your 401k, and still have more left to stash away, you can also contribute another roughly $5k to an individual IRA. This has the same effect.

If by chance you need the money before you retire, you can withdraw it, but it just comes with an additional 10% tax penalty, which might not be that bad assuming you’ve been saving for awhile and the money has grown. The way I see it, contributing to these accounts is a good way to “force” yourself to save. The incentive is to lower your taxable income initially, and the penalty for withdrawing discourages you from pulling it out before you actually need it.

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