3 Best Ways to Invest for Retirement

Covering your expenses in retirement will probably be the biggest financial goal of your life. Your retirement could last for decades, and once you stop getting a paycheck, your savings and investments will likely have to cover much of your expenses.

With that in mind, it’s incredibly important to start saving for retirement early, using tools designed to help you achieve that goal effectively and efficiently. These three approaches are among the absolute best ways to invest for retirement.

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No. 1: Roth 401(k)

A Roth 401(k) can be the most powerful tool you can use to invest for retirement, if your employer offers it and you have more than a decade or so until you retire. With Roth 401(k)s, you can invest after-tax dollars in the plan and then withdraw the money completely tax-free once you reach age 59 1/2, as long as you’ve had money in the account for at least five years. Plus, your contributions come directly from your paycheck, making it much less tempting to spend the money.

If you are at the beginning of your career, your income (and therefore tax burden) will probably be lower than later in your career. As a result, you won’t benefit as much from the instant tax deduction that a traditional style 401(k) offers. Early in your career, your money will also take longer to be compounded on your behalf, making the tax-free withdrawals much more valuable to you in retirement. That’s especially true when compared to traditional-style 401(k) plans, where your withdrawals are taxed as ordinary income.

In 2021, if you are under 50, you can generally contribute up to $19,500 to your Roth 401(k) plan. If you are 50 or older, you can make an additional $6,500 in catch-up contributions, making the normal limit $26,000.

No. 2: Roth IRA

The Roth IRA brings a ton of flexibility and important features that make it a very powerful retirement account. In particular, the withdrawal rules can be very friendly and flexible for both early retirees and those retiring at a more standard age. That makes the Roth IRA an important tool for earning earners who want to manage their retirement money effectively and efficiently.

What keeps it from the top spot is that its contribution limits are lower than a Roth 401(k) and have stricter restrictions on who can contribute. In 2021, the contribution limits will generally be $6,000 for those under 50 or $7,000 for those 50 and older. In addition, if your income is too high, your contribution limits will begin to taper. The limits start to come into play above $125,000 if you’re single, above $198,000 if you’re married and filing jointly, or if you have no income at all if you’re married and filing separately.

Still, as proof of the flexibility of a Roth IRA, you can typically roll money into your Roth IRA from other eligible retirement accounts to build your balance that way. Building a large Roth IRA balance is beneficial because the withdrawal strategies are so flexible.

First, you can withdraw money that you straight away contribute to your Roth IRA at any time and for any reason and pay no taxes or penalties on that withdrawal at all. You can then withdraw money that you rolled in a Roth IRA after being in the Roth IRA for at least five years and paying no taxes or penalties. In addition, once you are 59 and a half years old, you can withdraw money from your Roth IRA completely tax-free and penalty-free for the rest of your life, as long as the account has had money for at least five years.

But perhaps the most powerful advantage of all is that you never having to make a withdrawal from your own Roth IRA during your lifetime. Only inherited Roth IRAs are subject to required minimum distributions (RMDs), meaning that money in your own Roth IRA can continue to be compounded completely tax-free for the rest of your life. For retirees who have significant balances in traditional retirement plans, those RMDs can add significant costs and taxes that can be circumvented with a Roth IRA.

No. 3: Traditional 401(k)

If you’re later in your career and you don’t already have a large balance in traditional retirement accounts, a traditional 401(k) can be a very smart investment vehicle to use. Like a Roth 401(k), your contributions come directly from your paycheck, but they’re paid before taxes. If you’re in a high tax bracket, that instant deduction can be incredibly useful. Contribution limits are the same as for a Roth 401(k).

The main drawbacks of a traditional 401(k) are that your withdrawals are taxed as ordinary income in retirement and your balance is subject to those RMDs once you reach age 72. If your balance is not too large, the RMDs can be manageable. Indeed, coupled with the immediate tax deduction for your contribution and the fact that most people’s incomes drop once they retire, a traditional 401(k) can offer the best of both worlds.

After all, if your income is essentially $0 excluding your 401(k) withdrawals, those withdrawals will cover your standard deductions first and then low tax brackets before the taxes really start to bite. As a result, you can get a large tax deduction for putting in money while earning a high income and then withdraw money when your taxes are lower because your income is also lower.

Be careful not to let your traditional 401(k) balance get too big. Once you reach the age of 72, you should receive benefits from that account based on your age and account balance. These benefits are treated as ordinary income. As a result, they can increase your Medicare Part B costs, the portion of your Social Security income that is subject to taxes, as well as your regular tax bill.

If your projections of your balance start to get high enough that you fear those charges will bite you, consider rolling some of your balance into your Roth IRA. You pay tax on the conversion, but once the money is in your Roth IRA, you may never be able to pay tax on it again. Keep in mind that once your traditional 401(k) is subject to mandatory withdrawals, you’ll need to pull those withdrawals from your retirement accounts, but you can deposit any additional amount into your Roth IRA.

Start now

Regardless of how you choose to invest and plan your retirement, the most important thing you can do is start now. The earlier you start your journey, the longer you can make preparations work for you. That can both reduce the amount of money you need to get rid of each month and ultimately lead to a much more financially comfortable future.

You will never have more time before retirement than now. So make it today that you are going to make use of at least one of these three tools to build a better retirement for yourself.