Tax-deferred accounts, like employer 401(k) plans and traditional IRAs, defer taxes on your income. They allow you to pay less taxes now, but you’ll have to pay taxes on future withdrawals based on your income at that time.
Tax-exempt accounts, like employer Roth 401(k) plans and Roth IRAs, don’t lower your taxable income when you contribute, but you don’t have to pay taxes on any withdrawals you make from them at retirement.
Single and making less than $140,000? Paulino suggests contributing to a tax-deferred 401(k) or 403(b) up to whatever an employer will match and then contributing to a tax-exempt Roth IRA.
Single and making more than $140,000? Max out your 401(k)/403(b) and then contribute to a traditional IRA that you can later convert to a Roth IRA, Paulino says — or to a taxable brokerage account, which, unlike a 401(k) or IRA, you can withdraw from anytime without penalty. (If you’re single and your adjusted gross income exceeds $140,000, you’re not allowed to contribute directly to a Roth IRA.)
Self-employed? Invest in a traditional IRA, Paulino recommends. It’s tax-deferred, allowing you to pay less taxes right now.
This will depend on your priorities and what you can afford, as well as the limits on tax-advantaged accounts, Paulino says. For example, in 2022, employees will be able to make annual contributions of up to $20,500 to 401(k), 403(b), and most 457 plans, up from $19,500 in the previous two years.
Want to set it and forget it? Paulino suggests a target-date fund, which many 401(k) plans offer. It’s basically a type of mutual fund that the brokerage firm manages, adjusting the balance of assets as you near retirement.
Want to be more hands-on? Consult J.L. Collins’s The Simple Path to Wealth, which explains how to build a three index fund portfolio, which each fund tracking the U.S. stock market, the international stock market, and bonds, Paulino says.