TL;DR
- Investing is the only way to beat inflation over time and so is super important for retirement saving. Financial advisors recommend investing about 15% of your gross income.
- The earlier you start investing, the better.
- 401Ks and Traditional IRAs allow you to reduce your taxable income now, though you have to pay taxes on withdrawals later. They are therefore especially good options if you think you’ll be in a lower tax bracket during retirement.
- You contribute taxed income to Roth IRAs and then don’t have to pay taxes on withdrawals later. They are therefore ideal if you think you’ll be in a higher tax bracket later.
- Other differences include the potential presence of an employer match in 401Ks but not IRAs, income limits for IRAs but not 401Ks, more flexibility for investment options for IRAs, higher contribution limits for 401Ks, and greater flexibility for withdrawals for Roth IRAs.
- Having both a 401K and a Roth IRA is considered a good hedge against changes in your tax bracket.
- Financial advisors generally recommend the following order of operations: (1) Investing in your 401K up to the employer match, (2) Maxing out a Roth IRA, (3) Maxing out your 401K
Why Is Investing for Retirement Important?
Given how important investing for retirement is, you would think the types of retirement accounts would be named more intuitively. Like where the hell did Roth IRA come from? And why is it called a 401K? While we’re on things that should be different–why didn’t we learn how to save for retirement when we were teenagers and would have benefitted the most from compounding instead of as adults when we’re wondering… am I starting too late? If only there was an easy guide to help us decipher all the annoying terminology and tell us the important things we need to know!
Fun fact (or not so fun depending on how resentful you are about missing the boat on this one), if you invested $10,000 in the S&P500 when you were 18-years-old and never invested anything else, assuming the market issued an average return of 7% (the average over the past 30 years), you would have $240,457 by the time you were 65-years-old. By comparison, you’d have the following returns if you’d invested that money at later ages:
| Age Invested | Investment at 65 |
| 18 | $240,457 |
| 25 | $149,745 |
| 35 | $76,123 |
| 45 | $38,697 |
| 55 | $19,672 |
Are you also so sad no one mentioned this to us when we were blowing money on paper-thin Abercrombie shirts that helpfully had “Abercrombie” emblazoned on the front? Of course, not many 18-year-olds have $10,000 and enough of an acceptance of delayed gratification to actually invest it, but the point stands that investing early pays literally massive dividends.
Now that we’re adults (and probably dreaming of retirement every Monday morning), we hopefully know investing for retirement is important. However, it can be unclear which retirement vehicle we should actually put our money in. The intimidation around 401Ks, Roth IRAs, IRAs, etc. can lead people to decide investing is too hard or scary to pursue.
And that’s a huge bummer because there is about a 0.1% chance you’ll be able to comfortably retire if you don’t invest—basically the only exceptions to this are if you have a massive income and sock away most of it or come into a huge inheritance. That’s because your money is losing value from inflation almost every year. The only way to outpace inflation is to invest.
What’s the Difference between 401Ks, Traditional IRAs, and Roth IRAs?
Luckily, retirement vehicles are simpler than they sound. In the table below, I outline the key differences between a 401K, traditional IRA, and Roth IRA.
Should I Invest In a 401K, Traditional IRA, or Roth IRA?
A lot of people wonder which vehicle is best for them. Long story short, a combination is probably your best bet.
If you’ll be in a lower tax bracket when you take out your retirement income, then you’ll want to wait to pay taxes on your contributions until you take that money out, suggesting that a traditional IRA or 401K is best.
Alternatively, if you’ll be in a higher tax bracket when you take your retirement income out (which is probably the case if you’re early in your career), you should pay taxes on your contributions now. This means a Roth IRA is best for you.
The problem is that none of us have a crystal ball for what our income will do. On top of that, tax rates are historically low and we don’t know where they’ll be in the future—a lot of financial advisors think they’ll be higher. Given that, putting money towards both a Roth and traditional IRA or 401K can help us hedge our bets.
“Ugh, that sounds like so much work,” you might say! However, if you have an employer-sponsored retirement plan, you’re probably most of the way towards doing this already. Employer retirement plans almost always involve contributing pre-tax income and so follow traditional IRA logic. If you have one of these plans, you can open a personal Roth IRA through a brokerage account (Vanguard is a great option with reliably low fees and good performance).
You can also choose to allocate your Roth IRA to a target date fund which takes the year you expect to retire and automatically adjusts your investments so that they become more conservative as you approach retirement. This takes a lot of the guesswork out of making investment decisions.
When Investing for Retirement, What Order Should I Go In?
Still confused on what to do with your money? Many financial advisors recommend following the steps below. Think of the steps as levels of a game, if you accomplish a level and still have money left over, proceed to the next level.
- If you have a 401K with an employer match, contribute as much as you can to get the maximum employer match. For example, if your employer matches up to 5%, try to contribute 5%.
- Max out your Roth IRA
- Max out your 401K
- Still have money left over!? Look at you, you little saver! After this you might consider an HSA, annuity, taxable account or, you know, just enjoying your money now.
The rule of thumb is to contribute 12-15% of your gross income to retirement (this includes the employer match). Thus, if you contribute 5% of your income to a 401K and your employer matches 5%, you’ll also want to aim to contribute 5% to a Roth IRA and/or maxing out your 401K. However, this rule of thumb does not account for how much you earn, how much you intend to spend in retirement, and when you hope to retire, so do assess what numbers will help you reach your personal goals.
If you are a business owner or have a pension, your retirement options will be different and you may want to follow advice that is tailored to your profession.
Still want more advice on saving? Check out my very detailed guide to saving for any goal, my guide to creating a budget that will help you save money, my guide to paying off debt, or any of my other personal finance articles.
If you liked this article or think it would be helpful for others, please consider liking, subscribing (in the left sidebar), or sharing with others. And remember that I’m not a financial advisor so be sure to consult a financial professional before making any money decisions.
