Because Social Security will only provide so much income in retirement, it's important to start saving independently as early on in your career as possible. But the way you save for retirement can have a major impact on your total nest egg.
While you can save for the future with a traditional brokerage account, the money you make on your investments will be taxable year after year. On the other hand, tax-advantaged accounts, like IRAs and 401(k)s, let your investment earnings grow on a tax-deferred (or, in some cases, tax-free) basis during your working years. It's this benefit that helps so many workers maximize their savings.
How much can your savings grow?
A big part of building a strong nest egg is knowing how to invest your money. Thanks to the power of compounding, those who start setting money aside for retirement in their 20s or 30s stand a good chance of accumulating a considerable amount of wealth over time. But saving with a tax-advantaged retirement account can boost your earning power even further.
When you invest with a traditional brokerage account, and you make money from your investments, you're required to pay capital gains taxes any year you realize a gain. But for each year you pay taxes on your gains, you'll have less money left over to keep investing.
Tax-advantaged retirement accounts, like IRAs and 401(k)s, work differently. With the traditional version of either account, earnings on investments aren't taxed year after year. Rather, they're taxed during retirement, when the time comes to start taking withdrawals.
When you save with a traditional IRA or 401(k), you're allowed to start taking withdrawals once you turn 59 1/2 without penalty. Furthermore, you're required to start taking minimum withdrawals once you reach 70 1/2. But during your working years, you won't be obligated to pay taxes on your earnings, which means you can continuously reinvest them in full.
Roth IRAs and 401(k)s offer even more of a long-term tax benefit. While traditional IRAs and 401(k)s get to grow on a tax-deferred basis, Roth accounts get to grow completely tax-free. This means that once you put money into a Roth, you can earn as much as you'd like, and you'll never owe a dime in taxes. Furthermore, with a Roth, you won't have to worry about required minimum distributions, which means you can enjoy tax-free earnings for the rest of your life.
The difference can be huge
To illustrate the difference between a traditional brokerage account and a tax-advantaged retirement account, we have a calculator that highlights the benefits of going with the latter:
As an example, imagine you're able to save $5,000 a year for retirement over a 30-year period. Let's also assume that your investments bring in an average annual 8% return, which is a reasonable assumption for a stock-heavy portfolio. If you were to go with a traditional, taxable account, you'd accumulate roughly $419,000 over those three decades -- not too shabby. But if you were to save that money in a tax-advantaged account, you'd have close to $612,000 in time for retirement. That's nearly a $200,000 difference!
Though not everyone has access to a 401(k), you can open an IRA through your bank or financial institution. If you're working with a financial advisor, he or she can most likely handle the paperwork for you.
While traditional IRAs and 401(k)s do come with certain limitations -- namely, the fact that you'll incur a penalty for withdrawing your money before age 59 1/2 -- the growth opportunities they offer are more than enough to compensate. Currently, workers under 50 can contribute up to $5,500 a year to an IRA, and $18,000 a year to a 401(k). If you're 50 or older, you get a catch-up provision that raises these limits to $6,500 and $24,000, respectively. Maxing out either option will give you a chance to amass a sizable nest egg that will serve you well in retirement, and the sooner you begin saving, the more you'll benefit from that tax-advantaged growth.