An extra 2% might not seem like much, but it could be an opportunity to make a difference in your financial future.
Eliminate Credit-Card Debt
Image by Getty Images via @daylifeThe average variable interest rate on credit cards is more than 14%.2 Thus, a borrower with a $5,000 credit-card balance and a 14.5% interest rate would pay $1,872 in interest to retire the debt, assuming $125-per-month payments for 55 months — that’s about four and a half years!
If you have racked up some bills on your credit cards, consider using the extra 2% in take-home pay to help reduce or eliminate the debt, which could free up more of your future income to save and invest.
Increase Retirement Plan Contributions
Experts often recommend that you try to give your retirement plan a raise every year by increasing your contribution by an extra 1% or 2%. Putting the extra 2% you will get this year toward your workplace retirement plan is a relatively painless way to accomplish this objective.
For a worker earning $75,000 a year, the 2% payroll tax cut would be worth an extra $125 per month in take-home pay. By contributing $125 more each month for 25 years to an account earning a hypothetical 5% average annual return, a worker could accumulate an extra $74,440 toward retirement. Of course, this assumes the extra 2% contributions continue to be made even after the payroll tax cut expires after 2011. However, if the worker receives annual pay increases, he may be able to use them to maintain the higher contributions in future years without experiencing a reduction in take-home pay. This hypothetical example is used for illustrative purposes only and does not represent the performance of any specific investment. Fees and expenses are not considered and would reduce the performance described if included. Actual results will vary.
In 2011, the contribution limit for 401(k), 403(b), and 457 plans is $16,500 (or $22,000 for workers age 50 and older). If you aren’t making the maximum annual contribution to an employer-sponsored retirement plan, consider using the additional income to increase your monthly contributions. It could help you accumulate more for retirement.
Open an IRA
If you are already making the maximum annual contribution to a workplace retirement plan or don’t have access to such a plan, it might be time to open a Roth IRA or a traditional IRA. In 2011, you can contribute up to $5,000 ($6,000 for those age 50 and older) to all IRAs combined, as long as you have earned income. Contributions to a traditional IRA are generally tax deductible (subject to income limits if you are an active participant in an employer-sponsored retirement plan), whereas contributions to a Roth IRA are after-tax (income eligibility limits apply). Distributions from traditional IRAs and most employer-sponsored retirement plans are taxed as ordinary income. Qualified distributions from a Roth IRA (those made after the account has been in place for at least five years and after the original owner reaches age 59½) are free of federal income tax. Early IRA and employer-plan distributions (prior to age 59½) may be subject to a 10% federal income tax penalty.
Take Your Portfolio in a New Direction
If you are already doing everything you can to pursue your retirement objectives, you might consider investing in something that previously has been out of reach. Perhaps you are interested in an investment opportunity that is not available in your workplace retirement plan. Maybe you have always wanted to broaden your investment experience but never had the money. Remember that investments seeking to achieve higher rates of return also involve a higher degree of risk, so it’s a good idea to make sure you are using money that you won’t need in the near term.
Save for a Specific Financial Goal
The extra take-home income could be an incentive to open an investment account to pursue other important goals, such as saving for a child’s college education, a down payment on a home, a wedding, or a vacation. Because getting started is often the most difficult aspect of pursuing a new goal, using the payroll tax cut to open a new account may help you build momentum so that you will find other ways to keep the account growing.
If you simply plan to spend the extra income from the 2011 payroll tax cut, you could be passing up on an opportunity to adopt some new habits and put yourself in a better position to pursue your financial goals. Although the tax cut is temporary, it may be just the impetus to make a meaningful difference in your long-term financial situation.
1) Reuters, October 25, 2010
2) Bankrate.com, January 18, 2011 (average interest rate as of January 12, 2011)
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The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.
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