There are a couple popular strategies. One is to have contributions made directly to retirement accounts like 401(k)s. Another is to have your direct deposits split up, with one going into a dedicated savings account to ensure that some fraction of earnings never enters a checking account, which is specifically designed to facilitate spending.
Once savings have been set up, it’s important to decide where to house them and how much to dedicate toward retirement. It is usually a good idea to have several months’ worth of expenses in a liquid, accessible account at a bank or credit union. Once this emergency fund is built, young investors can dig into allocation for longer-term goals. Balance is extremely important at this juncture to avoid things like credit card debt.
401(k)s and other growth accounts
401(k)s have become very popular as pensions fade into obscurity, but it’s important to understand the strengths and weaknesses of these vehicles. 401(k) contributions accumulate on a tax-deferred basis, usually are withdrawn when investors are in a lower tax bracket, and often include some employer-matching funds to augment savings. These are all good things.
But it’s important to save elsewhere. Qualified retirement funds are functionally locked away until age 59 1/2, so they aren’t available in the event that a cash need arises — for example, to fund a small-business launch. Moreover, 401(k) savings are fully exposed to income tax rates at the time of withdrawal. If your tax rates are much higher in 40 years for some reason, it wouldn’t make sense to defer taxes.