YOU'VE HEARD IT BEFORE. You'll hear it again. But here it is anyway: Put as much money as you can, as early as you can, in a tax-deferred retirement account. The government has thrown you a bone. That's rare. You simply can't afford to waste it.
Retirement accounts aren't really magic, but they seem that way. That's because anything you earn in your typical 401(k) or traditional IRA account (i.e., a deductible or nondeductible IRA) is allowed to compound tax-deferred until you reach retirement age and start withdrawing the funds. Over a long period - say 20 years - the power of compounding will more than compensate for the fact that your accumulated profits will eventually be taxed at ordinary rates as you liquidate the account. Compounding is a multiplier effect: The more you have in the account, the faster it grows.
To see how much you save in a tax-free account, check out our applet. Say your tax bracket is 30%. If you invest $10,000 and earn an average 10% annual return for 20 years, you end up with a $57,275 profit in a retirement account but profits of just $46,044 in a taxable account. That $11,231 in taxes is nothing to scoff at.
If you have a 401(k) account, the benefits are even better. In addition to tax-deferred compounding, these company-sponsored plans allow you to contribute pretax dollars that your employer will often match, at least in part. Those two benefits alone will add more to your savings than any rate of return you could hope to get elsewhere.
The only thing better than tax deferral is outright tax avoidance (legal tax avoidance, that is). Roth IRAs offer this almost unbelievably lucrative benefit. It's true you have to contribute after-tax dollars to a Roth, unlike the pretax contributions you make to a 401(k). But after that you're in the clear. While you get taxed on your withdrawals from either a 401(k) or a traditional IRA, Roth withdrawals are generally tax-free after age 59 1/2. So if you qualify for a Roth IRA (see Which IRA Is Right for You?), start making contributions now. You'll be glad you did when you hit retirement age and start pulling out all your investment profits without having to share with Uncle Sam.
