If your employer offers a defined contribution plan, such as a 401(k) or
403(b), sign up and maximize your contributions as soon as you can. If your
employer matches some or all of your contributions, put in at least enough
to get all of the matching dollars. It's free money; don't pass it up.
Contributing to an employer plan provides a double bonus. First, Uncle Sam
will subsidize your retirement savings by deferring income tax on the
amount you save. So for every $1 you contribute to your account, your
take-home pay may be decreased by only 70 cents or so. Second, your
investments grow tax-deferred, giving a boost to your long-term returns. To
top it off, because the money is taken directly out of your paycheck, you
won't be tempted to spend it.
Need convincing? Let's say 2 people invested in the same mutual fund, but
one invested through a Vanguard® Roth IRA (where returns grew
tax-free*) and the other used a taxable account.
Each investor contributed $2,000 annually to the hypothetical account and
had an 8% return after expenses. A combined state and federal income tax
rate of 30% was imposed on the total return of the taxable account each
year. Both investors reinvested interest, dividend, and capital gains
distributions. What were the results after 40 years?
Despite identical investment returns, the Roth IRA grew to
$559,562 -- that's $263,800 more than had accumulated in the taxable
account.
*Most retirement plans are tax-deferred, not tax-free.
Withdrawals of earnings from a tax-deferred account such as a traditional
IRA or an employer-sponsored plan would be subject to tax as ordinary
income. Typically, you can't withdraw from a traditional IRA without paying
income tax plus a 10% federal penalty tax until you reach age
59½.