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Retirement account benefits

Lesson in Course: Finance at work (beginner, 5min)

What are some advantages of using retirement accounts?

Eureka!

What it's about: Retirement accounts are designed for long-term investing.

Why it's important: They provide tax advantages that make compounding even more effective.

Key takeaway: We can quickly reach our retirement goal by maximizing any company match and contributing our retirement savings to these types of accounts.

Retirement accounts make it easier to reach our retirement goals. They provide some powerful benefits for long-term investing by magnifying the magical effects of compounding. 

Tax Advantages

All types of retirement accounts provide tax advantages. These advantages allow us to make the most of our investment potential. Investments in retirement accounts grow tax-free, which enables compounding to happen faster.

Tax advantages are to incentivize saving for the future

Realized capital gains, interest, and dividends get taxed the year we earn them in other brokerage accounts. So if we made $1,000 in interest and dividends, we wouldn't be able to reinvest all $1,000 of it because of taxes. Paying taxes can pump the breaks on our account's growth if we sell our investments or invest in bonds and dividend-paying stocks.

Brokerage vs Retirement account growth

Let's say we invest $10,000 in a brokerage account, and it grows at 5% each year from interest or dividends - ballparking a 25% income tax rate. After 25 years, our account would be worth about $25,101.67. We would pay $5,033.89 in taxes over that period.

If we made the same investment in a tax-free retirement account, we would have $33,863.55 after 25 years. That's $8,761.88 more than the brokerage account, almost as much as our initial $10,000 investment!

 

Company Match

Retirement accounts from some employer-sponsored plans allow employers to match employee contributions. A match means that our employer will add money to the account when we do! While not all employers do this, it leads to rapid growth.

Understanding company match gives us free money

Thanks to compounding, the benefit is more than just the match itself. Assuming a reasonable long-term return of 7% each year, a $1,000 company match early in our career would be worth $5,427.43 after 25 years. That's almost 4.5 times more than what they initially added!

Company matches build the account value quicker than what we contribute ourselves. Larger account values compound faster, helping us reach our retirement goals sooner.

Actionable ideas

The benefits of retirement accounts compliment the effects of compounding, which only get stronger with more time. You can reach your goals by maximizing retirement savings in these types of accounts. It's a good idea to open a retirement account and contribute to it sooner rather than later.