The earlier you invest, the more time your money has to grow. But figuring out the exact accounts to use can feel overwhelming.
After setting aside money to cover daily expenses in a checking account and three to 12 months of expenses in a savings account, you should start looking into putting any additional 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 in cash, you’re actually losing money to inflation,” Bosse says. “Any extra dollars you have should be invested in growing for the future.”
With three investment accounts, you’ll have more flexibility to tap your money when you need it and more control over your tax bill now and later because each “bucket” offers different benefits, Bosse says.
How to best allocate your money across the different types of accounts will vary based on your income and situation, she says, but the bottom line is you should be using them to your advantage. Be sure to speak with a trusted financial professional for individualized advice.
Here are the three buckets she suggests and how they work.
1. Tax-deferred bucket
Examples: Traditional IRA, 401(k), 403(b)
Tax-deferred accounts, like a traditional 401(k) or individual retirement account, let you contribute pre-tax money from your paycheck into an investment account. This lowers your taxable income for the year you contributed, and your investments grow tax-deferred until retirement.
Withdrawals are taxed as income and usually penalty-free starting at age 59½. Taking money out earlier may trigger taxes and a 10% early withdrawal penalty.
2. Tax-free bucket
Examples: Roth IRA, Roth 401(k), Roth 403(b)
You contribute money you’ve already paid taxes on to Roth accounts. Your investments then grow tax-free, and once you reach 59½, qualified withdrawals aren’t taxed or penalized. Roth IRAs, in particular, also add flexibility by allowing you to withdraw money you’ve contributed at any time without penalty.
These accounts are ideal if you expect to be in a higher tax bracket in the future or want tax-free income later on, Bosse says.
3. Taxable bucket
Example: brokerage accounts
Taxable brokerage accounts let you invest money after taxes and withdraw at any time without penalty. While you’ll generally owe taxes on any realized gains, these accounts offer maximum flexibility for expenses outside of retirement, like a down payment on a house or a vacation, because you can access your money whenever you need it, Bosse says.
Start by taking advantage of your company match
You don’t have to open all three accounts at once, says Patrick Huey, certified financial planner and owner of Victory Independent Planning in Portland, Oregon.
Start by checking to see if your employer has a company match 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 get older — making it smarter to pay taxes now when you’re in a lower tax bracket.
However, even if it is through a tax-deferred account, “if there’s a match available, you should do what it takes to get it,” because it’s free money from your employer that boosts your retirement savings, Huey says.
Using all three investment ‘buckets’ gives you options
Generally, experts recommend saving around 15% of your annual income before taxes for retirement, including any company match.
Bosse says the purpose of splitting your money into three accounts is to give yourself options, whether it’s to make big purchases, lower your current tax bill or reduce what you’ll owe in the future.
“I would think of it in terms of not investing for your retirement, but investing for your future flexibility,” Bosse says. When you have money in your three buckets, “You can be working because you want to, not because you need to. You can travel the world. You can do other things.”
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