Start saving and investing now
401(k), 403(b) and 457 plans: employer-provided retirement savings plans to which eligible employees can make salary deferral (pretax) contributions. Earnings in these plans grow on a tax-deferred basis. Also, salary deferral contributions are not taxed until you take them out of the plan.
The main difference between the three types of plans is the type of employer eligible to sponsor the plan for its employees:
|Plan type||Eligible sponsors|
|401(k) plans||Most public and private sector employers|
|403(b) plans||Primarily public schools, tax-exempt organizations and nonprofits|
|457 plans||Primarily state and local governments|
Individual retirement account: a savings account that you open outside your workplace and that typically offers major tax advantages. A "traditional IRA" lets you contribute pretax income, up to an annual limit, toward investments that grow on a tax-deferred basis. With a "Roth IRA," you can contribute only after-tax income, but qualified distributions are tax free.
Section 529 plan: an investment vehicle, authorized by Section 529 of the Internal Revenue Code, that offers you tax advantages as you save for higher education.
If you haven't yet begun to focus on saving and investing for your future, there's no better time than now. The sooner you start, the greater your chances of reaching your financial goals, whether they're short-term goals like buying a car within the next year, or longer-term goals, which might include college tuition or retirement.
Start saving now, even if you can only manage to save a little
Saving even a small amount of your income on a regular basis can help you build security and peace of mind. Soon after you start investing what you save, each dollar you invest will start reaping the rewards of a process called compounding. Compounding is when your investment generates earnings, which then get reinvested in order to generate their own earnings, and so on. Over time, compounding can add a lot of fuel to the growth of your savings.
There are several ways to pay yourself first on a convenient, automatic and regular basis. For example, if you have access to a 401(k), 403(b) or 457 tax-deferred savings plan at work, you can save for retirement through regular payroll deduction contributions to this plan. When you contribute to your plan on a pretax basis, you reduce your taxable income which, in turn, reduces your taxes. Neither your pretax contributions nor any of the earnings get taxed until they are withdrawn. If your employer matches part of what you contribute, you may decide to contribute the full amount that will qualify for the match. If you choose not to contribute the full amount, keep in mind that’s similar to missing out on free money from your employer—and you will also miss out on compounding as well as the potential tax-deferred growth of your account. This may be an option you want to revisit in the future, based on your income.
Your employer may also help you save for any goals of your choice by having part of your paycheck deposited directly into your personal savings account. Even if you don't have direct deposit available at work, your bank may be able to set up automatic transfers from your checking account into some form of savings or investment account.
Protecting your security with a rainy-day fund
A rainy-day fund is another way to make savings a top priority. Such a fund is a reserve of cash you can dip into in the event of a financial hardship, like a job loss or serious illness. A general rule of thumb is to have enough cash set aside to cover at least six months' worth of living expenses. If and when you take money out of the fund, work on quickly restoring the balance so you'll have enough cash available for later use if needed.
The best place to keep a rainy-day fund is in an account where your money will be safe and liquid (easy to get to quickly), like a money market account at a bank or a money market mutual fund account.
Saving and investing for goals
Beyond putting a rainy-day fund in place, it's important to decide what your financial goals are and then prioritize among them. Only then will you be ready to make sound decisions about how to save and invest for each goal.
You will have a world of investments to choose from, including cash equivalents such as bank savings accounts, short-term certificates of deposit, U.S. Treasury bills and money market funds; fixed income investments such as bonds, bond funds and guaranteed insurance products like fixed annuities; and equities, which are stocks and stock funds. It will be up to you to choose, with professional guidance if you prefer, an appropriate mix of investments based on your goals, your time horizon for achieving them, the level of return you'd like to try to get and your tolerance for risk.
You can invest through a wide variety of savings and investment plans and accounts, many of which offer significant tax advantages. Earlier in this discussion we mentioned workplace savings plans, and traditional and Roth individual retirement accounts (IRAs) and how they can be great vehicles for retirement savings beyond any pay you contribute to a plan at work. You may also want to consider how a section 529 plan can be a tax-effective way to save and invest for your child's college education.