A number of alarming signs forecast that Social Security won’t be able to provide today’s younger professionals nearly as much money for retirement as it gives baby boomers (if any at all).
As such, savvy retirement planning is more important than ever. Once you’ve begun saving regularly, you need a good place to put it. So why open an individual retirement account? This part of the equation is clear: Opening a tax-advantaged account to save for retirement helps you bank significantly more money over the years. And the sooner you get started, the better.
But saving alone isn’t enough – you have to save strategically. By applying these rules of thumb, your savings will add up faster than you thought possible in an IRA.
Pay yourself first. Consumers have piles of bills and day-to-day expenses to pay, but if you let these take priority, they'll eat away at your paycheck before you find time to funnel some of the money into savings. To prevent this from happening, consider paying your future self first. Taking a chunk of savings should be the first thing you do when you receive a paycheck, gift or bonus. Automate it (if possible) so you don’t have to think twice about where to put the money.
Skip the savings account. While it’s OK to have a savings account at a big bank for short-term expenses, there are better ways to save for long-term goals like retirement. Today’s interest rates are incredibly low due to quantitative easing, so you should put your money some place it can generate more returns for you.
Embrace the beauty of compounding. As your money in the account continues to grow – due to your investments’ returns and the returns on their returns – your money will grow faster and faster; time is your best friend.
Why open an IRA? Unlike a 401(k) offered by your employer, you set up an IRA on your own, which provides more flexibility and less hassle if you change jobs. Put simply, an IRA is an account you can open so your money can grow tax-free over the years, saving you more for retirement than you otherwise could without the tax benefits it gives you. Why? The government wants to encourage you to save enough money to retire on, and such tax breaks are perks you should take advantage of.
If your employer offers a good 401(k) plan, that is an option also worth considering – and, if you have enough saved up, ideally you can have both a 401(k) and IRA, and max out your annual contribution to each.
Roth or no Roth? Now that you know an IRA is critical to a successful retirement plan, you need to know which type of IRA to open. With a Roth IRA, you pay on each deposit but can later withdraw the money tax-free. Meanwhile, with a traditional IRA, you pay taxes only when you withdraw the savings.
So, which is better? The answer varies, as it depends whether you expect your tax bracket and taxation rates to increase or decrease. If you can afford to do so, opening both types of retirement accounts is the best strategy, so you're prepared for either scenario.
Susan Lyon is a senior strategy analyst for NerdWallet Investing, a financial literacy organization that helps investors select better mutual funds, figure out where to open IRA accounts and make smarter investment decisions overall.