In this chapter:
Introduction
Retirement savings plans
The 401(k) plan
IRAs
Roth IRAs
The IRA decision
How your savings grow
Some (minor) drawbacks
Dividing your savings
Inflation & taxation
A newfangled pension
Questions & answers
Security and your 401(k)
The scoop on IRAs
Your savings priorities
If you're self-employed
Financial cramming
 

A Word About Inflation and Taxation

Personal finance articles and books often offer dramatic examples of the rewards of saving without ever mentioning inflation. So far in this chapter I haven’t done much better. It’s time for me to come clean.

Although saving over a long period of time really is a good idea, the fact is it won’t make you as rich as it might seem from the examples given so far. Inflation can drastically reduce the purchasing power of the dollar over time. Consider, for example, the scenario I outlined at the beginning of this chapter; the $168,627 you’d have 40 years from now would not buy nearly as much as $168,627 can buy today.*

This doesn’t mean you shouldn’t save. As the numbers show, you still come out way ahead if you start saving in a retirement account while you’re young—even after inflation. When money is allowed to grow for decades without being taxed, the results are extraordinary. 

Consider the following example. Suppose you put $2,000 into each of two accounts—a Roth IRA and a taxable account—in 2001. Let’s also assume that each account earns 8% a year, the annual inflation rate is 3%, and you’re in a 25% tax bracket (including federal, state, and local taxes). After 30 years, the $2,000 in the IRA will have grown to approximately $8,300 (in 2001 dollars). The $2,000 in the taxable account, on the other hand, will only have increased to about $4,750 (again in 2001 dollars). The bottom line: You will have earned more than twice as much ($6,300 versus $2,750) by keeping your money in a tax-favored account than by putting it in a taxable one.

*There's a less obvious way inflation comes into play in this example. If you decided to save for ten years starting at age 25, you'd be making your ten annual $1,000 deposits many years earlier than if you waited until you turned 35 and then invested $1,000 a year for 30 years. Because $1,000 buys more today than it will many years from now, each of the $1,000 deposits you'd make from age 25 to 34 would buy more than each of the $1,000 deposits you'd make if you waited ten years and saved from age 35 to 65. Thus the benefits of saving early are offset somewhat by inflation.