How Tax-Advantaged Accounts Build Assets

Last Updated Dec 10, 2010 3:50 PM EST

Part six in a series with videos that teach older kids about money:

Tax-free or tax-deferred growth in savings accounts such as the Roth IRA or traditional employer-sponsored 401(k) plan are cornerstone investment vehicles because the tax savings allows you to invest more and build retirement funds more quickly. Understanding how tax-advantaged accounts boost long-term savings is one of five core competencies needed to reach financial security, according to researchers at the Financial Literacy Center.

You can talk to your young teens and nearly adult kids about why they should get started as soon as they have taxable income, or show them this video:

Or invite them to read this narrative:

It's payday and roommates Becca and Emily are making plans to go out for the evening. Emily touches up her makeup as Becca opens her paycheck, only to discover that while she made $800 that week, the check is for only $640. She hates how much they take out for taxes.
Emily explains that the reason she signed up for a 401(k) retirement account when she started her new job was to protect her money from getting eaten up by taxes. But Emily's explanation simply confuses Becca, who doesn't understand what a retirement account has to do with taxes.
Emily sits down with her roommate to explain. Everyone pays income tax on his or her salary. For example, if you're in the 20% tax bracket, then 20% of your salary goes to the government and you don't get to use it. But if you start a traditional 401(k) retirement plan, you can contribute pre-tax money to that account. You can contribute a portion of your salary straight to investments, without paying taxes on it, so there's more money for you. With a 401(k), your contributions grow tax-free. You don't pay taxes on the account until you retire, when you probably won't be earning as much and therefore will be taxed in a lower tax bracket.
While this sounds like a good idea, Becca asks what would happen if she wanted to take money out before retirement. Emily explains that if she withdraws money before she is 59 and a half, she will have to pay taxes and will get hit with a penalty too. So it's not usually a good idea.
But the problem for Becca is that she doesn't think her employer offers a 401(k) plan. Emily explains that there are other options. IRAs are another type of retirement account and you don't have to get them through your job; you can get them yourself. As with a 401(k), there are traditional and Roth varieties. Traditional IRAs protect your money from taxes when you put money in. And Roth IRAs protect your money from some taxes at the end, when you withdraw money during retirement.
Those aren't the only types of retirement accounts available that protect money from taxes. Lots of non-profit and government jobs offer similar types of retirement accounts that work in the same general way as a 401(k) and IRA. When you're saving for retirement, it really pays to take advantage of these types of accounts and not give any more away in taxes than you have to. That's why Emily contributes to a 401(k).
Becca and Emily head out the door to their usual happy hour spot, with Becca thinking about how great it is to have friends who can give you financial advice and Emily thinking about whether the cute new bartender will be at happy hour.
Research shows that these simple devices -- a video or narrative (both prepared by the Financial Literacy Center) -- will have a lasting impact on the financial knowledge and behavior of young adults who view or read them.

More video and narratives to share with kids on MoneyWatch:

More on MoneyWatch:
  • Dan Kadlec

    Daniel J. Kadlec is an author and journalist whose work appears regularly in Time and Money magazines. He is the former editor of Time’s Generations section, which was written and edited for boomers. Kadlec came to Time from USA Today, where he was the creator and author of the daily column Street Talk, which anchored the newspaper's business coverage. He has co-written three books, including, most recently, With Purpose: Going from Success to Significance in Work and Life. He has won a New York Press Club award and a National Headliner Award for columns on the economy and investing.