Retirement accounts are accounts that hold our investments, they are not investments in themselves. They are worth discussing because an effective way to lower your tax bill is to do the majority of your investing through a retirement account.
Basically, the government says you can have a tax break if you invest in your own retirement. If you keep your money in that account until you reach retirement age (59 and a half), you will be free from tax penalties.
Starting a retirement account is investing in your future self. If you're wondering whether or not a retirement account is right for you, the answer is yes. Sometimes, it's hard to imagine ourselves ten, twenty, or thirty years down the road, but saving for retirement early means more money and financial security for you later on.
What retirement account should I get?
Two types of retirement accounts exist:
- Those funded by you.
- Those funded by your employer.
The first step is to ask your boss about your company's retirement plan. She will explain how retirement accounts work, or, will direct you to someone who can. There will be options that you can choose to invest in.
Before choosing what you will invest in, you should first decide which type of account you want. Whether it is an employer sponsored plan, or an individually sponsored plan, there are again two options:
- "Roth" accounts
- Non-"Roth" accounts
Accounts with the word "Roth" give you a tax break later. Accounts without the word "Roth" give you a tax break now.
Here's how it works:
When you put money in a retirement account - any retirement account - it will grow free of taxes. Usually selling investments at a profit means you must pay taxes. Likewise, when you receive dividends or interest on an investment, that profit is taxable once you receive it. Not inside a retirement account. Retirement accounts are not subject to this type of taxation, allowing your money to grow faster.
You do eventually have to pay taxes, though. Non-Roth accounts give you a tax break now. For example, if you are in the 30% tax bracket, and put $1,000 into your retirement account, you can deduct 30% (or $300), off your taxes that year. You get the tax break now.
Roth accounts do not allow you take a tax deduction for your contribution. Instead, when you withdraw money at age 59 and a half, you are not taxed at all. When in doubt, choose Roth. For most people, it is the better choice.
Deciding whether or not to go with your employer's plan
Consider your employer's plan if:
- They offer matching contributions. (It is in your best interest to take advantage of this. Your employer is paying you to participate.)
- It allows you to save more money than an individual plan. (Individual plans have limits to what you can put away. Employers have limits, too, but they are typically higher.)
- Income limits prevent you from participating in an individual plan. (Sometimes an individual plan won't work if you make too much).
"Why Bother" by Peter Bielagus