Where to Invest?

Q: Help! I am a recent college graduate and I just landed my first job. My employer offers a 401(k) with a Roth feature and I heard that I am also eligible to contribute to a Roth IRA based on my income. With so many options, I don't know what to do!

A: If this scenario sounds familiar, don't panic! We commend you for choosing to save for retirement early in your career. Deciding where to put your retirement money can be confusing. We will help you break down the options.

In the past few decades, employers have been moving away from traditional employer-funded pensions to fund employee retirement. Most large employers now offer employees the option to self-fund retirement by offering a 401(k) plan to eligible employees. Some employers are kind enough to offer a company match, to encourage employees to participate in saving for retirement. The company match is free money, but only those employees who contribute the required percentage of income to the 401(k) plan get the benefit of these extra employer dollars. It's like a raise for retirement or a guaranteed return of 100% on your investment. Put your savings dollars here first! Beyond that required percentage, contributions to a 401(k) plan may or may not make sense depending on your other options and needs.

Before exploring the other retirement planning options you mentioned, a few words about 401(k) plan contributions and withdrawals. Contributions to a 401(k) plan are made with pre-tax dollars. There are often a dozen or so investment options to choose from within a 401(k) plan and fees can vary widely among the selections and depending on the plan provider, often large mutual fund companies such as Fidelity and Vanguard. The investments grow tax-deferred and are taxed as ordinary income when withdrawn in retirement. There are penalties for withdrawals made before age 59 ½ from a traditional 401(k) plan. We don't recommend making withdrawals from retirement accounts, but certainly not from a 401(k), which levies a 10% penalty for early withdrawals.

In 2006, the IRS introduced the Roth 401(k) to the retirement plan scene. Not all 401(k) plans offer this feature, but for those employees lucky enough to have this option, we strongly recommend a closer look. Here's why: While a typical Roth IRA has income limits on contributions, the Roth 401(k) does not carry those limits so even high earners can amass Roth savings for retirement. As with a Roth IRA, contributions to a Roth 401(k) are made after-taxes and grow tax-deferred. The best part is that withdrawals on contributions and earnings are tax-free in retirement, assuming the account has been open at least five years and you are at least 59 ½. This could amount to significant savings if tax rates increase, as scheduled and often predicted.

One major difference between the Roth IRA and the Roth 401(k) is how early withdrawals (before 59 ½) are treated. Whereas with the Roth IRA, you can withdraw your contributions tax-free at any time, early withdrawals from a Roth 401(k) are taxed and penalized. While we do not recommend using retirement accounts as your emergency fund, it is comforting to know you can withdraw all of your contributions in case of need from your Roth IRA.

Even if you direct all of your contributions in the company plan to the Roth 401(k) side, any company match is made to the traditional 401(k) side of your account, because again, it's like receiving a bigger salary and you will owe income taxes on the withdrawals (and penalties if you are under 59 ½).

Another point to weigh in your decision about where to stash your cash is whether you will have to make required minimum distributions (RMD) beginning at age 70½. A Roth IRA does not require that you make withdrawals during your lifetime. As with a traditional 401(k), the Roth 401(k) has RMD requirements that begin at 70½ (see our previous article on Roth IRA conversions for more on this topic).

If your employer does not offer a retirement plan at work and you make more than the income limit, your best starting bet is likely a traditional IRA. If you are married and your spouse has a retirement plan at work, your deduction may be limited depending on your income. Just remember that the total contribution limit to all IRAs, Roth and traditional, is $5,000 in 2010 ($6,000 for those over 50), so don't max out your contribution to both types of IRAs or you will have to make a corrective distribution.

Most hard-working Americans need to have cash on hand for emergency purposes and preferably not their Roth IRA contributions. In these tough times, we are encouraging clients to keep eight months of expenses in cash reserves for a rainy day, more if you work in a freelance capacity. You never know when your refrigerator will finally give out or whether you will get injured in that dodgeball tournament and are unable to work for a few months. It could happen at the same time and if you're not prepared, you could end up with mountains of debt to dig yourself out of that could take years to eliminate. We don't mean to be so pessimistic, we just want you to consider the facts of life and prepare accordingly.

So now that we've looked at some of the retirement saving options available to you, what should you do if cash flow is limited? Contribute enough to receive the full match in your Roth 401(k) (or traditional 401(k) if your employer doesn't offer the Roth feature yet -and talk to HR about amending the plan), but then direct leftover money to build an emergency fund, then a Roth IRA, if eligible. In addition to penalty-free withdrawals on contributions, you will have thousands of investment options in your Roth IRA account, instead of the dozen or so options selected for your by your employer's human resources department (which may not have the skills to select a good, low-cost menu of options). After the match, your emergency reserves, and Roth IRA contributions are funded, then direct your money to the Roth 401(k) if you still have money to sock away.

These are general guidelines not personal investment adivce and may not apply to your individual situation. As with all financial planning issues, there are a number of moving parts and contribution limits even in these basic strategies. Give Hartman Financial Planning a call to help implement your own personal game plan.




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