Retirement Savings Strategy for 20 Somethings: 401K, IRA, Roth IRA

There are very few things in personal finance that are more important than saving and investing for one's retirement. This has become increasingly obvious during the recent market crash and ongoing global economic recession. For a young 20 something adult there are several things to learn about before developing a saving and investing strategy for retirement.  The first thing to do is decide what savings vehicle is the best for the individual. These options include a 401K, a IRA and a Roth IRA. First lets go through some background knowledge about what each of these accounts.

A 401K is a tax deferred account that is provided by an employer to its employees. In these employee sponsored plans the employee elects a percentage of their before-tax income to contribute to the account. This is known as the employee contribution. Many companies elect to also contribute to the account based on how much the employee is willing to contribute. Most companies setup a program where they match X percent on the first X percent the employee contributes (example: 100% match on the first 3% of the employee's before tax income).

There are two big advantages of a 401K:

1. The money contributed is not taxed up front and is only taxed one time when withdrawn. This allows for a larger starting amount that can appreciate with compounding interest.
   
2. Any employee contribution is essentially free money. In the event that an individual is lucky enough to get a 100% match they are guaranteed a 100% return on their money before they even invest it.

There is one main disadvantage to a 401K:

1. A 401K plan only allows the individual to invest in a small number of funds provided by the employer.  Typically 401K's do not have the quality or quantity of options that an IRA has.
   

A traditional individual retirement account (IRA) is another type of tax deferred account. A bank or brokerage house serves as custodian of the account and determines the funds that the individual can invest in.  Typically these custodian institutes allow the individual to invest in every type of fund imaginable.  Any individual is able to open a traditional IRA as long as they have the money to make the minimum contribution. However, an IRA does have a maximum annual contribution which for 2010 was $5,000 for ages 49 and under, and $6,000 for ages 50 and above.

A traditional IRA has two advantages:

1. Like the 401K a traditional IRA is a tax deferred account where the money is only taxed upon withdrawal. This gives a head start to compounding interest.
2. The traditional IRA has more quality and quantity of investing options.  In an IRA an individual can invest in nearly anyway they choose.
   

The traditional IRA has two main disadvantages:

1. Depending on your age you may only contribute $5,000 or $6,000 per year. This means if you are lucky enough to have more that that amount to save towards retirement each year you will have to look at another account type for the rest of your savings.
2. An individual must start taking distributions from the account at 70-¹/₂. This forces the individual to take money out every year even if they do not want to.
   

A Roth IRA is similar to a traditional IRA in structure. It is managed by a bank or brokerage institution. However, there are many differences between the two. A Roth IRA is not a tax deferred account.  The money contributed to a Roth IRA is "after tax" money, but the money is not taxed when withdrawn from the account.

The Roth IRA has a coulple advantages:

1. The money contributed to the account is "after tax" money.  This means that at any time the money contributed can be withdrawn from the account (not including interest) without penalty.
2. There is no age at which distributions are required.  The individual can leave their money in the account for as long as they want. This makes a Roth IRA a good way to leave money as an inheritance.
   

The Roth IRA has one disadvantage:

1. Depending on your age you may only contribute $5,000 or $6,000 per year. This means if you are lucky enough to have more that that amount to save towards retirement each year you will have to look at another account type for the rest of your savings.

As a young adult I take the following steps when I save and invest my money. This plan offers good tax advantages, and it also has a good risk/reward balance.

First, I invest in my 401K up to the point where I get the maximum possible match from my employer.  This guaranteed return on investment is too good to pass up and vastly outweighs the lack of options in the plan.

Second, I contribute the maximum possible ($5,000 per year) to my Roth IRA. Although this is not a tax deferred plan I prefer the Roth to a traditional IRA due to its lack of required distributions and its freedom to withdrawal principal if an emergency happens.  Also, the Roth IRA is a good hedge against higher income taxes in the future.  Nobody knows what tax brackets will exist 30 years from now, but with the probable end of the Bush tax cuts there is a good chance that they will increase going forward.

Lastly, any remaining money I have (which is not much and for some individuals may be none at all) to put toward retirement I put into a traditional IRA.  As discussed above, since the traditional IRA has better options than a 401K and the same tax advantages I prefer to put the remainder of my money here.