When saving money for retirement, it’s important to know which “box” you choose to put your money in. What do I mean by “box?” In this case, it’s a term that can apply to any container for your money that will protect it from taxation — an important feature if you’re going to save money and let it grow exponentially over several years.
Over the past few decades, tax law has allowed Americans to save their money in a variety of boxes. Your employer may offer a 401k plan, which deducts money from your paycheck pre-tax and saves it in an separate investment account. (403b and 457 plans work in a similar way.) These plans make saving for retirement automatic and often come with an employer match, which is another way of saying free money. If your employer matches your own contributions dollar-for-dollar up to 3% for example, that means you’ll get a 3% raise just for contributing (a 100% rate of return — something you won’t find anywhere else in the investment world).
But what if you don’t get an employer match? What if you don’t have a 401k plan at all? That means you may have to strike out on your own and open an Individual Retirement Account (IRA). A great place to open one of these is with a discount broker such as Charles Schwab, Vanguard, or several others. Currently, you can contribute a maximum of $5,000 to either a traditional IRA, a Roth IRA, or a combination of the two. A traditional works in the same way as a 401k, where the money you put away is saved pre-tax, which means you get a tax-deduction each year for the money you save, but when it comes time to retire, the money you withdraw will be subject to ordinary income tax. In a Roth IRA, you save money that has already been taxed, but it grows tax-free and can be spent tax-free in retirement.
So which is better, a pre-tax traditional IRA or a post-tax Roth IRA? Many people prefer the Roth IRA for a variety of reasons. One is that income taxes will likely be higher in the future due, and paying the taxes now will be one way to avoid them. Another is that if you save the maximum $5,000 in a traditional IRA, you will still have to deduct taxes from that amount in retirement, where with a Roth IRA, the full $5,000 stays in your pocket. That means a Roth IRA allows you to save more money for retirement than a traditional IRA.
Whichever box you choose, the most important thing to remember is to fill it up consistently over time. We’ll cover what to put in your “box” in the next session.