The sooner you invest, the longer it will take for your money to grow. However, it can feel overwhelming to know the exact account to use.
After you have money in your checking account to cover your daily expenses and three to 12 months’ worth of expenses in your savings account, you should start thinking about putting additional income into three different investment “buckets,” says Jamie Bosse, a certified financial planner and senior advisor at CGN Advisors in Manhattan, Kansas.
“If you hold too much cash, you actually lose money to inflation,” Bosse says. “The extra money should be invested in future growth.”
With three investment accounts, each “bucket” has different benefits, giving you more flexibility to use your money when you need it and more control over your taxes now and later, Bosse says.
The best way to allocate your money between different types of accounts will depend on your income and situation, but the bottom line is that you need to use your accounts to your advantage, she says. If you require personalized advice, please always consult a trusted financial professional.
Here are the three buckets she suggests and how they work.
1. Tax deferral bucket
Examples: Traditional IRA, 401(k), 403(b)
Tax-deferred accounts, like traditional 401(k)s and individual retirement accounts, allow you to contribute pre-tax money from your paycheck to an investment account. This reduces your taxable income in the year you donate, and any growth in your investment is tax-deferred until retirement.
Withdrawals are taxed as income and are generally penalty-free beginning at age 59½. If you withdraw your money earlier, you may be subject to taxes and a 10% early withdrawal penalty.
2. Duty free bucket
Examples: Roth IRA, Roth 401(k), Roth 403(b)
Contribute money you’ve already paid taxes on to a Roth account. The investment then grows tax-free, and once it reaches 59 1/2, no taxes or penalties are due on qualified withdrawals. Roth IRAs in particular also offer more flexibility, as you can withdraw contributed funds at any time without penalty.
Bosse says these accounts are ideal if you expect to be in a higher tax bracket in the future or if you need tax-free income later on.
3. Taxable Bucket
Example: brokerage account
A taxable brokerage account allows you to invest after-tax funds and withdraw them at any time without penalty. Although you typically have to pay taxes on realized gains, these accounts give you maximum flexibility for retirement expenses, such as down payments on a home or vacation, because you can access the money whenever you need it, Bosse says.
First, take advantage of in-house matching.
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 finding out if your employer has a company matching program that matches your own contributions with an additional amount to your retirement account.
Early in your career, Huey suggests contributing to a Roth 401(k) or Roth 403(b) rather than a tax-deferred 401(k). Because your salary is likely to increase as you get older, it makes sense to pay taxes now in a lower tax bracket.
But even if it’s through a tax-deferred account, it’s free money from your employer that will boost your retirement savings, so “if you have the terms available, you should do what it takes to get it,” Huey says.
Using all three investment “buckets” gives you options
Generally, experts recommend saving about 15% of your annual pre-tax income for retirement, including a company match.
Bosse says the purpose of splitting your money into three accounts is to give yourself choices, such as whether to make a big purchase, lower your current taxes, or reduce future debt.
“I would look at it in terms of not investing for retirement, but investing for future flexibility,” Bosse says. With money in three buckets, “I can work because I want to, not because I have to. I can travel the world. I can do other things.”
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