The law in the United States is designed to encourage each working citizens to save for his or her own future. Through tax advantages, there are subtle incentives for investing in certain types of accounts. These incentives encourage financial literacy, boost use of the economic machine of the financial industry, and shift the burden of supporting the elderly from corporate pensions to the public.
Regardless of whether you think this is a good approach to supporting a population with an expanding lifespan, this is today’s environment. If you envision a future where you can do what you’d like to do with your life, unfettered by financial constraints despite a lower or zero income from work, you have to get on board with the concept of saving and investing for yourself.
There’s nothing stopping anyone for saving for their future by storing cash — whether in a mattress or in a safe. It’s more beneficial to do something else with that money, however, so you don’t lose purchasing power due to inflation and so you aren’t exposed to a loss in the event of a burglary. Rather than hoarding cash for retirement, take advantage of the various incentives that will help your money grow.
Because different types of retirement accounts have different levels of tax advantages and other benefits, it helps to know which should be the highest priority. Don’t miss a great opportunity to allow your money to grow as strong as possible in any investment.
Keep in mind I am not a financial planner or adviser. These thoughts come from my own analysis and thoughts about retirement investing. You can get personalized advice and suggestions by speaking with a financial adviser. I can’t make your decisions for you.
Priority 1: 401(k) account with (or up to) an employer’s matching contribution
The 401(k) account itself allows you to deduct your contribution from your taxes, so you owe less to the government in the years you’re saving for retirement. Your investments in the 401(k) grow tax-free. You only pay taxes when you withdraw your money from the account, when you are possibly in a lower tax bracket (although that is a major assumption about the future).
Even better than these tax advantages are incentives from employers. Many employers offer some type of matching arrangement. In one such arrangement, the company would match your 401(k) contribution dollar for dollar up to a certain amount. That amount may be a percentage of your salary like 3 percent. With this benefit, if you invest 3 percent of your $50,000 salary, you save $1,500 for the future and your employer gives you an additional $1,500.
That immediately doubles your money. You cannot ignore a 401(k) matching contribution because there is nowhere else you can get an immediate 100 percent return. This benefit becomes less valuable once you start contributing beyond the limit of your employer’s matching contribution. And if your employer does not match anything, you may want to skip this step entirely, because we will come back to the 401(k).
Priority 2: Roth IRA
While investing with a traditional 401(k) presupposes you will be in a lower tax rate during retirement, there’s a good chance that is not going to be a correct assumption. There are some forces working towards lower income tax rates in retirement. Social Security benefits will likely be lower decades in the future, reducing your income. Other income from your investments will likely be long-term capital gains, today taxed at a lower rate.
At the same time, the economy might require higher tax rates in the future. We’re benefiting today from the lowest tax rates in American history. This might be the time to pay taxes if you think the economy has no way to survive without higher tax rates in the future. The concept of favorable tax rates on long-term capital gains might disappear. And if you save and invest diligently, you may be able to generate more income than you expect.
There is a strong case for believing that the tax you’re paying today might be the lowest rates you’ll ever pay. Take advantage of that by investing in a Roth IRA. You don’t get a tax deduction like you would with a traditional IRA, but you won’t need to pay tax on your contributions or your earnings when you withdraw your Roth IRA funds in retirement. There’s another assumption inherent in this: that the law surrounding Roth IRAs doesn’t change.
Priority 3: Maximize contributions to your 401(k)
If you’ve maximized your Roth IRA, look back at your 401(k). By contributing more to your 401(k), you can take advantage of the tax benefits already mentioned. Because you already maximized your employer’s matching contribution, the only benefit left is the tax deduction and tax-free growth of your investment. This is still something to take advantage to lower your tax bills today and throughout the rest of your income-earning life.
Not every employer offers a 401(k). The non-profit I used to work for eventually offered a similar plan, a 403(b), with the same benefits, but other employees might not be so lucky. If a 401(k) isn’t available, you can fall back on a traditional IRA. Rather than investing the full $5,500 into a Roth IRA, split your total contribution between the Roth IRA and a traditional IRA. With a traditional IRA, you receive a tax deduction (subject to income limitations) and tax-free growth, like a 401(k).
If you have self-employment income, consider opening an Individual 401(k). The benefits are the same as an employer-sponsored 401(k), but you contribute as both the “employer” and the “employee” and receive reduced self-employment taxes in addition to an income tax deduction.
401(k) investors who like the idea of paying tax today in favor of reduced tax bills in retirement, those who like the idea of the Roth IRA, can often choose to designate some or all of their 401(k) contribution as a Roth 401(k). Whether this is offered is up to the employer.
Priority 4: Maximize contributions SEP IRA
The SEP (Simplified Employment Pension) IRA provides an opportunity for self-employed individuals to put aside more of their income for retirement and receive a tax deduction at the same time. The contribution limit for the SEP IRA can be much higher than the one for traditional and Roth IRAs, but otherwise, the SEP IRA operates the same way from a tax perspective as the traditional IRA. The limit for investing in an SEP IRA is 25 percent of income up to a maximum that changes almost every year, though there are some nuances to that calculation.
Priority 5: Invest anything else in a taxable account
Once you’ve maximized all the above investment types, you’ve run out of tax-advantaged options. While there are other avenues for tax savings, like deferred compensation, restricted stock, and carried interest, these are likely not available to most taxpayers. You will probably need to save more than just the above in order to achieve financial independence by the time you’d like to stop working, unless you are willing and able to limit your expenses.
Frugality can go a long way in making your retirement dollar stretch, but most people envision a life without worrying about whether they can afford to do a particular activity. A life like that requires saving a healthy amount of money over time. If your tax-advantaged opportunities are complete, you can save more by investing in a taxable investment account.
I suggest choosing the same discount broker to handle your IRAs and your taxable accounts. You usually don’t have much choice with a 401(k), but choosing a low-cost provider of index mutual funds, like Vanguard, is one way to use efficiency to help your investments reach their potential.
Get started even if you don’t read this article
The most important thing in any retirement plan is getting started immediately. I could have started ten years before I did and had a much better head start. You can’t make up for lost time. So don’t worry about your plan being perfect from the beginning. Doing anything is better than wasting time trying to know everything about investing before making your first contribution to a retirement plan. You’ll have time to work out the details. Start today.
Published or updated November 7, 2012.