A 2016 end-of-year financial survey by NerdWallet found that 55% of individuals saving for retirement do so in a regular savings account. And for individuals between the ages of 18 and 34 -- so-called "millennials" -- the figure jumps to 63%.
While it's wonderful that these people are saving for retirement at all, they should be putting most or all of that money into tax-advantaged retirement accounts such as employer-sponsored 401(k)s and individual retirement accounts. Even taxable brokerage accounts are better options than savings accounts, though they don't offer any special tax benefits.
Here's why it matters so much where you stash your retirement savings.
When you start building your retirement fund, the first place you should start is with an employer-sponsored retirement plan such as a 401(k), if you have access to one. And the first thing you want to check is whether your company will match your contributions. For example, your plan might say that your employer will contribute $0.50 for every dollar you contribute until your contributions reach 6% of your annual salary -- and beyond that, you're on your own. Essentially, you could contribute 6% of your salary to get the full match, which would come to 3% of your salary. That would automatically bring your saving rate from 6% to 9% -- and give you an instant, guaranteed return of 50% on your investment, which is virtually unbeatable. No one should pass up free money, so if nothing else, save enough in your employer-sponsored plan to earn the full match.
The immediate tax benefits of traditional retirement accounts
Even if you don't receive a matching contribution, participating in a traditional 401(k) can provide you with an immediate tax break. Your contributions to a 401(k) will be taken out of your wages before they're taxed, which lowers your taxable income, and thus your income tax liability, for that year. For example, if your annual salary is $50,000 and you contribute $5,000 to your 401(k), your taxable income for the year is $45,000.
Meanwhile, if you have earned income but don't have access to a retirement plan at work, you can still fund an individual retirement account (IRA). You won't get an automatic tax break, but you can deduct your contributions from your taxable income (assuming your income falls below certain limits), which will also reduce your tax liability for the year.
The ongoing tax benefits and growth potential of all retirement accounts
While personal savings accounts can play an important role in your overall savings strategy -- especially for emergency funds -- they don't earn you enough interest to grow your wealth. In fact, odds are your money's value won't even keep up with inflation if it's sitting in a savings account. Most individuals will have to look to investable assets to build a nest egg that can fund a retirement that may last 20 or 30 years.
What separates a regular brokerage account from a retirement account like an IRA is that retirement accounts are afforded preferential tax treatment. And unlike cash in a savings account, money within a brokerage account or retirement account can be invested in assets like stocks and bonds. Retirement accounts in particular are geared for the long term. One of the greatest benefits of tax-sheltered retirement accounts is that you can defer paying taxes on any investment gains generated within the account for decades. In an ordinary brokerage account, meanwhile, your gains and dividends will be subject to taxes that can hinder your portfolio's growth.
The future tax benefits of Roth retirement accounts
Contributions to a Roth 401(k) and a Roth IRA are always nondeductible, meaning they are made with after-tax dollars. However, unlike distributions from traditional retirement accounts, which are taxed at ordinary income rates, all qualified distributions from Roth accounts are tax-free. For a closer look at how a Roth IRA and a Roth 401(k) work, see here.
While individuals usually rely on a combination of different income sources during retirement -- Social Security, personal savings, personal retirement accounts, workplace retirement accounts, and more -- the benefits that come with saving in tax-sheltered retirement accounts are unmatched. Whether you decide to go for the traditional variety, a Roth, or some combination of the two, these accounts should be your first choice of where to put your retirement savings.
The Motley Fool has a disclosure policy.