The earlier you start investing, the longer your money has to grow. But let’s be honest: figuring out the right accounts for your investment can be a bit daunting.
Once you have enough in your checking account for everyday expenses and savings set aside—ideally between three to twelve months’ worth of expenses—it’s time to think about investing. Jamie Bosse, a certified financial planner and senior advisor at CGN Advisors in Manhattan, Kansas, suggests funneling any extra income into three main “buckets.”
“Holding too much cash means you’re actually losing money due to inflation,” Bosse explains. “So, it makes sense to invest that extra cash for future growth.”
Each of these three investment accounts offers unique benefits that can give you more flexibility when you need access to funds, as well as better control over your tax situation both now and in the future, according to Bosse. The way you choose to distribute your funds across these accounts will vary based on your income and personal circumstances, but ultimately, you should be using these accounts to work for you. If you need tailored advice, it’s always wise to consult a financial professional you trust.
Here’s a breakdown of the three buckets and how they can function for you:
1. Tax Deferred Bucket
Examples: Traditional IRA, 401(k), 403(b)
These traditional tax-deferred accounts allow you to invest pre-tax dollars from your paycheck, which lowers your taxable income in the year you contribute. Any growth in this investment remains tax-deferred until you retire. Withdrawals will be taxed as income, but typically, you can access these funds penalty-free starting at age 59½. Keep in mind, early withdrawals may incur taxes and a 10% penalty.
2. Tax-Free Bucket
Examples: Roth IRA, Roth 401(k), Roth 403(b)
In this bucket, you contribute money that’s already been taxed. It then grows tax-free, and once you hit age 59½, you can make qualified withdrawals without owing taxes or penalties. Roth accounts are especially advantageous because they allow you to withdraw contributions anytime without penalty, making them a solid choice if you anticipate being in a higher tax bracket in the future or simply want tax-free income down the line.
3. Taxable Bucket
Examples: Brokerage account
Here, you invest after-tax dollars and can generally withdraw your funds whenever you want, with no penalties. Although you’ll pay taxes on any realized gains, these accounts provide maximum flexibility for unexpected expenses, like a home down payment or a vacation, says Bosse.
First, Make the Most of Employer Matching
You don’t need to set up all three accounts at once, notes Patrick Huey, a certified financial planner and owner of Victory Independent Planning in Portland, Oregon.
First, check if your employer offers a company matching program, which adds a certain amount to your retirement account based on your contributions. Huey advises that early in your career, you might want to prioritize a Roth 401(k) or Roth 403(b) over a traditional tax-deferred account. This is because you could be in a higher tax bracket later on, so paying taxes now at a lower rate could be beneficial.
However, regardless of whether it’s a tax-deferred account, that employer match is free money that can really boost your retirement savings; “if the terms are there, it’s worth taking advantage of,” Huey emphasizes.
Utilizing All Three Investment Buckets Provides Flexibility
Most experts suggest that you should aim to save around 15% of your annual pre-tax income for retirement, which includes any company matches.
Bosse highlights that having your money spread across these three different accounts allows for a variety of choices—like making significant purchases, reducing your current tax burden, or minimizing future debt. “Instead of merely investing for retirement, think of it as investing for future flexibility,” she says. With funds in all three buckets, it opens up opportunities—“I can work because I want to, not because I have to. I can travel, I can explore other passions.”
