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This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Saving for your retirement is the biggest investment you'll ever make. The decisions you make with your retirement investing can make or break what could prove to be a third or more of your entire lifetime.
With so much on the line, you need all the help you can get. And as it happens, one of the biggest resources that can help you retire rich comes from perhaps the most unlikely source: the IRS and the tax laws it's in charge of sticking to taxpayers.
Take the money and run
Of course, gifts from the government can be double-edged swords, and this one is no exception. Tax-favored retirement accounts can save you huge amounts of money over the course of your lifetime, but they also add greatly to the complexity of your finances. Rather than having a single investing account that holds all the money you've set aside for whatever reason, tax breaks can turn your retirement portfolio into the accounting equivalent of alphabet soup. Here's a sample:
- Want to save for retirement through work? You'll most likely need a 401(k) plan account that lets you set aside pre-tax money for your golden years -- sometimes with an added bonus from your employer.
- Thinking about saving a bit more on the side? An IRA could be the answer, with both traditional and Roth flavors vying for your consideration.
- Changing jobs? Now's your chance to roll over your old 401(k) into a brand new IRA.
- Own your own business? Add SARSEP, SEP IRA, SIMPLE IRA, and other more esoteric choices like Keogh to the mix.
With so many terms and choices to juggle, it's a wonder anyone successfully saves for retirement.
The simple way to save
But it doesn't have to be that complicated. Below are the three things you absolutely need to know to be a better retirement saver:
1. Pay now or pay later.
The key to understanding tax-favored retirement accounts is that there's no such thing as a free lunch. You'll pay taxes either up front or when you withdraw the money, so you need to structure your investments to take maximum advantage of each type of account.
Roth IRAs, for example, involve using after-tax money to save in a vehicle that offers tax-free growth. So the best investments for Roth IRAs are those that produce the largest amount of total income. Over the past five years, stocks such as Green Mountain Coffee Roasters (Nasdaq: GMCR ) , Baidu (Nasdaq: BIDU ) , and priceline.com (Nasdaq: PCLN ) have fit that bill -- stocks that still today have plenty of potential for even more price appreciation in the years to come.
On the other hand, traditional IRAs give you an immediate tax benefit combined with tax-deferred growth until you retire. When you take money out of the account, though, you get hit with tax. So with traditional IRAs, the key is to make the most of that tax deferral, making high-dividend stocks like Cellcom Israel (NYSE: CEL ) and American Capital Agency (Nasdaq: AGNC ) very attractive choices. You won't avoid tax, but keeping that income sheltered for decades can make a big difference to your results.
2. Be smart about beneficiaries.
If everything goes well, you won't need all of your retirement money. But don't make the mistake of thinking that someone you name in your will stands to receive your leftover IRA or 401(k) money. No, only the person you name in a beneficiary designation form gets that money -- so if you haven't checked it for a while, you should do so soon to make sure your loved ones don't get a nasty surprise after you're gone.
3. Cut your costs.
Some investors obsess over exactly which investments to use for retirement savings. But much more important is making sure you don't pay more in fees and other costs than you absolutely have to.
In particular, 401(k) plans have a bad reputation for high-cost investment choices. So when you have a choice, stick with low-cost investments like index ETFs. Whether it's an ETF tracking the Dow Jones Industrials (INDEX: ^DJI) or a dividend-stock ETF such as iShares DJ Select Dividend (NYSE: DVY ) , there's no reason to pay an arm and a leg for the investments you want.
You can do it
Trying to invest for something that's years or even decades away can be tough, especially in hard times like these. But the effort you spend now will pay you back many times in the future. By taking advantage of helpful tax laws, you can make sure you get the retirement you deserve.
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.