The earlier you invest, the more time your money has to grow. But determining the exact accounts to use can seem like a daunting task.
After you’ve set aside money to cover daily expenses in a checking account and three to 12 months of expenses in a savings account, you should start considering putting any extra income into three different investment “buckets,” says Jaime Bosse, a certified financial planner and senior advisor at CGN Advisors in Manhattan, Kansas.
“If you have too much cash, you lose money to inflation,” says Bosse. “Any extra dollars you have should be invested in growth for the future.”
With three investment accounts, you’ll have more flexibility to use your money when you need it and more control over your tax bill now and later, because each “bucket” offers different benefits, says Bosse.
The best way to allocate your money between different types of accounts will vary depending on your income and situation, she says, but ultimately you should use them to your advantage. Be sure to speak to a trusted financial professional for personalized advice.
Here are the three buckets she suggests and how they work.
1. Deferred tax bracket
Examples: Traditional IRA, 401(k), 403(b)
Tax-deferred accounts, like a traditional 401(k) account or individual retirement account, allow you to contribute pre-tax money from your paycheck into an investment account. This reduces your taxable income for the year you contributed and your investments grow tax deferred until retirement.
Withdrawals are taxed as income and generally penalty-free starting at age 59½. Withdrawing money early may result in taxes and a 10% early withdrawal penalty.
2. Tax-free bracket
Examples: Roth IRA, Roth 401(k), Roth 403(b)
You contribute money you’ve already paid taxes on into Roth accounts. Your investments then grow tax-free and, once you reach 59½, eligible withdrawals are neither taxed nor penalized. Roth IRAs, in particular, also add flexibility by allowing you to withdraw the money you’ve contributed at any time without penalty.
These accounts are ideal if you plan to be in a higher tax bracket in the future or want tax-free income later, says Bosse.
3. Taxable bracket
Example: brokerage accounts
Taxable brokerage accounts allow you to invest money after taxes and withdraw at any time without penalty. Although you’ll typically owe taxes on any gains you make, these accounts provide maximum flexibility for expenses outside of retirement, like a down payment on a house or a vacation, because you can access your money when you need it, says Bosse.
Start by taking advantage of your business match
You don’t have to open all three accounts at once, says Patrick Huey, a certified financial planner and owner of Victory Independent Planning in Portland, Oregon.
Start by checking to see if your employer has a matching program where they will contribute an additional amount to your retirement accounts that matches your own contributions.
Early in your career, Huey suggests contributing to a Roth 401(k) or Roth 403(b) instead of a tax-deferred 401(k).) because you’ll likely earn a higher salary as you age, making it smarter to pay taxes now when you’re in a lower tax bracket.
However, even though it’s a tax-deferred account, “if there’s a match available, you have to do what it takes to get it” because it’s free money from your employer that boosts your retirement savings, Huey says.
Using the three investment “buckets” gives you options
Generally, experts recommend saving about 15% of your annual pre-tax income for retirement, including any company matching.
Bosse says the point of splitting your money across three accounts is to give you options, whether it’s making big purchases, reducing your current tax bill or reducing what you’ll owe in the future.
“I think it’s not about investing for your retirement, it’s about investing for your future flexibility,” says Bosse. When you have money in all three buckets, “You can work because you want to, not because you need to.” You can travel the world. You can do other things. »
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