ratemyadvisor January 30, 2023

If you’re an adult human being, you’ve probably been told by one or more authority figures in your life that you should be putting money away for your retirement. If you’re anything like me, however, you’ve been persistently ignoring this advice because retirement is waaaay too far away to be thinking about right now. 

Well, as it turns out, the authority figures happen to be right in this case. Stick around and we’ll break down the various types of retirement accounts you might have access to and do our best to convince you that putting money away now is absolutely, 100% worth it. 

Types of Retirement Accounts

There are many different types of retirement accounts you might have access to in the United States, however the two most common are Individual Retirement Accounts (IRAs) and 401(k)/403(b)s. 

Both IRAs and 401(k)/403(b)ss earn interest by investing the money deposited into a variety of stocks, equity funds, private securities, corporate bonds, etc. Where, exactly, money in any of these accounts goes is rather complicated, but the basic idea is that by investing in a diverse portfolio, the money you deposit is expected to grow consistently and at a much higher rate than you could expect from a standard savings account. 

Of course, there are some risks associated with any sort of investing. The market could crash (like it did in 1929 and 2008), in which case you might lose quite a bit of money until the market recovers. All that’s pretty unlikely, however — you’re much more likely to die in a car crash on the way to work than you are to lose all your retirement funds in a market crash. 

IRAs

Individual Retirement Accounts are exactly what they sound like: retirement accounts that you contribute to as an individual. There are two different types of IRAs, Traditional and Roth. The difference is in when you pay taxes on the money you contribute. 

In a Traditional IRA, you can write off the money you deposit as a deduction on your taxes, so you save on your annual tax bill. Don’t get too excited though: you pay those taxes when you cash in your IRA at retirement. 

A Roth IRA, on the other hand, taxes your contributions as you make them. Then, when you withdraw your funds when you retire, you do so with no tax penalty. 

Which is better? Well, that depends. If you can predict what your tax situation is going to be after you retire, then you can choose whichever option will give you the greatest benefit: if you’re in a low tax bracket now but expect to be in a higher one when you retire, you should open a Roth IRA, pay the lower tax now, and then live tax free after retirement. If the opposite is true, a traditional IRA makes more sense. 

The problem with that kind of calculus is that it’s difficult (if not impossible) to predict what your tax situation is going to look like decades down the road. So what to do? Speaking with a financial advisor is probably the best decision, since they likely know the ins and outs of financial planning much better than you do (even after reading helpful blogs like this). 

Here’s an interesting question to consider that might help you make the decision: when do you want to have more money, now or later? With a Roth IRA, you’re sort of forced to save more, because you’re paying taxes now in order to get a benefit down the road. With a traditional IRA, on the other hand, you save money now. That gives you more flexibility as to what to do with that money — you could invest it, contribute more to your retirement account, or (and, let’s be honest, this is what is probably going to happen) you could spend it on stuff like craft beer and/or avocado toast. 

If having the extra money immediately will help you make ends meet or live the lifestyle you want, perhaps a traditional IRA is the way to go. If you want to ensure that you have the money to retire comfortably later, Roth IRAs might be better for you. 

401(k)s & 403(b)s

401(k)s and 403(b)s are both employer-sponsored retirement accounts that allow you to make pre-tax contributions directly from your paychecks. Many employers will even automatically deposit a certain percentage of employees’ salaries into a 401(k) account, or match a portion of employee contributions. 

Just like with IRAs, you can choose between traditional 401(k)s or Roth 401(k)s, though traditional ones are much more prevalent. 

The only difference between a 401(k) and a 403(b) is the type of job you have: 401(k)s are for people who work at for-profit companies, whereas 403(b)s are for employees of government agencies or nonprofit organizations. 

Why to Start as Early as Possible

The reason you want to start contributing to a retirement account as early as humanly possible is because of a little something called compound interest. Basically, you earn interest based on your initial principal and all of the interest you’ve accumulated up to that point. 

So, the longer you have money in such an account, the more interest it earns over time, and the more money goes into calculating how much interest you earn each year. The math on how compound interest adds up is almost unbelievable.

Let’s assume you begin depositing $200 per paycheck into an IRA at age 25 and continue until age 65, you will have deposited about  $365,000 into your account. Assuming a 6% average annual return, you’re going to have about $580,000 in the account when you retire. For the record: that’s a fairly conservative estimate of what you can expect from compound interest. Most experts assume between 7% and 10% growth annually in IRA accounts (just for fun, the same deposits with an 8% return make you a millionaire when you retire).

On the other hand, if you start saving the same amount at age 35 and continue until age 65, you will end up depositing about $215,000 into the account, which will grow to about $319,000 by the time you retire. That’s an extra $260,000 you’ll have to work with once you retire even though you only deposited about $150,000 more into the account. So, once all that math resolves, that’s a free $110,000 you get just from starting your retirement savings by the age of 25 and sticking with it. And, if you’re a little more realistic with the interest you can expect to earn, it’s a heck of a lot more than that. 

How that compares to a savings account

Now, you may be thinking that there’s no reason to commit to something so serious and long term as an IRA when you could simply stash your savings in an account at your bank. After all, it would be easier to access that way in case of an emergency, right?

Wrong. 

Compared to the 7% – 10% annual growth you can expect from your IRA account, your measly savings account is going to look pretty pathetic. The most generous interest rates for high-yield savings accounts top out at around 4%, and the vast majority of them are below 1%. 

If we do the same retirement math (depositing $200/paycheck starting at age 25) but with savings account interest rates, you end up with much less going into retirement: $399,000 if you’re one of the lucky ones with a 4% interest rate at your bank, and a mere $205,000 if you’re only earning 1% (which is most of us). If you compare that to the conservative estimate of $580,000 you can expect from an IRA, it really is a no-brainer. 

Even a little helps

Even if you’re at the point in your life where contributing $200 every paycheck to an IRA is a laughable proposition, you can start preparing to live comfortably in retirement: contributing a mere $10 per paycheck starting at age 25 would amount to over $60,000 by the time of retirement. 

TLDR

Whether you’re 25 or 50, it’s never too early (or too late) to start contributing to a retirement account. Because of the magic of compound interest, the amount of money your money earns while invested in a retirement account grows exponentially. 

At the end of the day, the difference between starting contributions to your retirement account at 25 vs. 35 could exceed $260,000 by the time you retire (and that’s with making $200/paycheck deposits). 

In terms of types of retirement accounts, you have a couple of options: 

  • 401(k)/403(b) vs IRA: if your employer offers retirement benefits, they will come in the form of a 401(k) or 403(b) plan. For-profit companies offer 401(k)s, whereas government agencies and nonprofit organizations offer 403(b)s. Other than that, they’re identical. 

If your employer doesn’t offer any sort of retirement benefits, you can open an Individual Retirement Account (IRA), which is basically the same thing as a 401(k) or 403(b) except you’re all on your own when it comes to depositing money into it. 

  • Traditional vs. Roth: Both 401(k)/403(b)s and IRAs come in two forms: Traditional and Roth. Traditional retirement accounts allow you to contribute money to them before it’s taxed, and you can write contributions off as a deduction on your taxes. Then, when you cash in your account at the age of retirement, you pay taxes on the disbursements. 

Roth accounts, on the other hand, tax you up front, before you contribute money to them. Then, when you retire, you can take disbursements from the account tax-free.