Contribute to Tax-Deferred Retirement Plans

Ah, the beauty of compound interest.
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Ignoring this advice is like warming yourself by the embers of a million bucks that could have been yours.

Consider Bob and Bill

Whether it's a retirement plan offered by your employer -- a 401(k), 403(b) or 457 plan, for instance -- or an individual retirement account

IRA, which you handle yourself, you should sock money away in tax-deferred retirement accounts. Here's why: Each is designed to help us bolster our retirement nest egg beyond the pittance that is Social Security. Each year you're allowed to contribute $2,000 to your IRA and up to about $10,000 in your 401(k).

Plus, beginning in 2002, these limits will start to increase because of the new tax bill passed in June. Here are the two key reasons why you should try to take advantage of both retirement plans:

  • Tax-deferred growth: You don't have to pay taxes on any gains made in these accounts until you withdraw your money, clearing the way for what's often called the "magic of tax-deferred compounding" over time. That means your investments' gains mount up faster than in a standard taxable account where the government charges you a toll each year for any gains you make. Keeping that money invested, rather than in Uncle Sam's pocket, can add up over time. Consider Bob and Bill, twin brothers who both invested $10,000 in a stock mutual fund that averaged an 8% annual gain over 30 years. They should end up with the same amount of money, but Bob bought his shares in a tax-deferred account in which he didn't owe any taxes each year. Bill, on the other hand, bought the same fund in a standard taxable account. The result: Bob's investment is worth more than $100,000, while Bill's is worth less than half that.
  • Lower taxes today: If you choose a traditional IRA and don't make too much money, you can claim a tax deduction for every dollar you invest in that account. You can't claim a deduction for a Roth IRA, but you don't owe any taxes when you withdraw money from that account. And no matter how much money you make, the cash you invest through your company's retirement plan isn't considered part of your taxable income, so you pay less taxes whenever you contribute money to that account.

Beyond these perks, some retirement plans let you use the money to cover key expenses like a first home. And some companies even match part of your contributions, which translates to free money that grows tax-free over time. The bottom line: Make sure you're not ignoring these accounts.

10 Things You Should Do Before You Invest

  • Figure out what you're worth.
  • Set your goals and figure out how much they cost.
  • Spend less than you make.
  • Build an emergency savings fund.
  • Pay off your credit card debt.
  • Insure yourself against the unexpected.
  • Contribute to tax-deferred retirement plans like 401(k)s and IRAs.
  • Consider using software to keep track of your money and help with your taxes.
  • Be your bank's thriftiest customer.
  • Check out your credit report.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.