It’s never too early to start saving for retirement. While it may be the last thing on the mind of young investors faced with a volatile economy, difficulty finding full-time employment, and student loan debt, the importance of preparing for retirement cannot be overstated. Moreover, even a basic understanding of retirement savings accounts can help individuals decrease their tax burdens and increase their returns on investments.
Probably the most well-known form of retirement savings are defined-contribution pension accounts, better known as 401(k) and 401(b) plans. These allow employees to contribute a portion of their salary — as much as $17,500 in 2014 (limits are set for tax purposes) — to a retirement savings account, which they may then invest as they see fit. Some employers will even match their employees’ contributions as a form of additional compensation. Most importantly, the money contributed to 401(k)/(b) accounts is taxed-deferred: it is not considered taxable income, nor is it taxed until it is withdrawn from the account. This can result in a significantly lower tax burden for both the employee and employer, if they match contributions, for the same level of compensation. While some 401(k)/(b) plans have additional fees, they are often far outweighed by the benefit provided by the tax-advantaged status.
Another well-known form of investment savings are Individual Retirement Accounts (IRAs), which are similar to 401(k)/(b)s, except they are not sponsored by an employer. Thus, IRAs do not have matching contributions advantages, and the maximum contribution limit is usually lower than a 401(k)/(b). On the other hand, they generally offer a greater deal of control over investment choices. It is also possible to have both a 401(k)/(b) and an IRA, which indirectly increases the total yearly cap on contributions (although there are additional rules that must be followed in such cases).
The obvious advantage of 401(k)/(b)s and IRAs is how they are taxed. Because contributions to these plans are tax-deferred, they lower the marginal tax rate for years with contributions (in the U.S., the income tax rate increases along with total income). When compounded over forty or more years, these tax savings can substantially increase investment returns. When the contributions, and their returns, are withdrawn during retirement, they are taxed as income. Because total income, including withdrawals, is likely to be much smaller after retirement than before, this money is often taxed at a lower rate than it otherwise would have been.
While there are certain rules governing how the money in these accounts may be invested, they are largely under control of the individual owners. Investors should place as much of their income as possible into these accounts. Doing so not only increases the total long-run return on their investments, but also ensures that those investments help secure a prosperous retirement by penalizing early withdrawals.
Traditional 401(k)/(b)s and IRAs are often the best option for retirement saving. However, in certain situations, investors should consider Roth IRAs or 401(k)/(b)s (assuming employer offers this alternative). Named for U.S. Senator William Roth (R-DE), these plans are an inversion of their traditional alternatives: contributions are taxed, but withdrawals are not. Depending on the circumstances facing the individual investor, it may be prudent to make contributions to Roth accounts, or split contributions between Roth and traditional accounts.
There are other, more esoteric means of saving for retirement, but traditional Roth 401(k)/(b)s and IRAs are by far the most common. While they may have a reputation for complexity, they are actually rather straightforward, and having even a basic understanding of how they work can help investors increase their returns in the long-run, thus ensuring a better-funded retirement at the end of their lives.