Now don’t be scared of the term tax advantage, it just means there’s a tax bonus for investing in IRAs and 401ks. The bonus could be delaying paying taxes until you withdraw the money, paying taxes on it now instead of when you take the money out or a tax reduction. It’s the perk of investing money, long-term, for your future. If you’re building your retirement nest egg, these are the types of accounts you want to be maxing out—put as much money as they’ll allow.
The accounts are the tax benefit—you still have to decide what investment to put inside. Think of IRAs and 401ks as a tax-advantaged basket. To help your money grow, you’ll need to buy mutual funds or bonds to put in the basket. The basket is the tax perk and what you’re carrying in the basket are your investments.
Let me break down the basics on IRAs and 401ks.
In both 401ks and IRAs, there are traditional and Roth versions. Traditional means you pay taxes when you withdraw the money at 70 ½ years old (you can’t take the money out until then without a tax penalty.) The funds you’re going to deposit into a traditional account are taken and put in there before you’re paid. So the amount of income you receive is lower. Now your taxable income is lower and may decrease the amount of taxes you must pay. Yeah!
A Roth means you get paid, and some money is withheld for taxes, and then you put money in a Roth account. The money grows (compounding interest, baby) until you’re 70 ½, and then you can take it out tax-free, but not free. In case, you haven’t heard it, “There’s no such thing as a free lunch.” You paid up front for the privilege to take it out later in life without paying tax on it.
Individual Retirement Accounts or Arrangements (IRAs) are just that, for the individual.
They aren’t set-up through an employer but instead through brokers, credit unions, or banks, to name a few. The place to create your IRA varies in the services they provide and by how much they cost. Spend time researching and learning the best place to start an IRA. It doesn’t make sense to spend hours price comparing new furniture and not put hours into investing for your future—think about it.
There are rules and guidelines for both Traditional and Roth versions of IRAs. Instead of listing them out, I want you to get it from the horse’s mouth, so there’s no confusion. Here’s a link to the IRS breakdown of IRAs.
Next up, 401ks.
This type of long-term savings is through your employer. Now there are all kinds of employer retirement accounts. Some are 403b (college, hospitals, churches), 457 (state and local government) and thrift savings plans (federal government), but I’m only going to go into 401k and save the rest for another time. Being able to invest in a 401k is a great benefit. One, because you’re investing but two, you often get a match of the savings you contributed from your employer. Always say yes to free money, save whatever amount necessary to get the match. When you elect the 401k, the HR department will give you a booklet of info on the company’s 401k program. Please don’t let this get lost in the mountains of paper at your house. It’s important info to decide your investments. The same goes for 401ks as IRAs, put time into researching and reading your different options. If you spend less time reading about your 401k than the time you spend reading Facebook, then you’ve got to switch your priorities up.
For all the deets and rules on 401ks, here’s the source.
The point of all the tax advantages in IRAs and 401ks is to squirrel away as much as you can gather to prepare for your future self. If you’re on the fence about saving for retirement, think about the lifestyle you want at 80 years old. Do you want to relive your college years in a dorm with roomies and mismatched furniture or would you like to be in a comfortable house with all the things you need?