NEW YORK (MainStreet) For younger professionals who are closer to the beginning of the retirement savings cycle than the end, figuring out how to start saving money begins with figuring out where to start saving the money. After they figure out the savings vehicle, the question is how much they should be saving when retirement seems so far away and their salary can often be fairly modest in the early stages of their career.
"It can be difficult to convince someone who is 25 years old to put money away each month now for something that will not occur in 40 years or longer," says Neal McGrath, a partner with Carson Institutional Alliance in Pittsburgh, Pa. "The importance of having financial independence and the safety of stable benefits in case you lose your job or something happens in retirementthat is so foreign to them."
The first step is to understand the differences between three common savings vehicles: a traditional 401(k), a Roth 401(k) and a Roth IRA. The majority of young professionals who have an employer-sponsored retirement plan will be enrolled in a traditional 401(k), although an increasing number of companies are also adding a Roth 401(k) account to employee options as well.
"As a savings vehicle, they are nearly identical," John Napolitano, chairman and CEO of U.S. Wealth Management in Braintree, Mass, says of the two 401(k) offerings. "It comes down to a tax issue."
The biggest difference between a traditional 401(k) and a Roth 401(k) is that with the former you contribute money tax-free and pay taxes when you make distributions; with the latter you pay the taxes upfront and then make tax-free distributionsalthough if your employer offers a match on the Roth 401(k) then that portion is taxable income. Both vehicles impose a maximum contribution limit of $17,500 annually for people younger than 50.
By comparison, a Roth IRA allows a maximum annual contribution of $5,500 for all people younger than 50. Like a Roth 401(k), taxes are paid upfront and the distributions are made tax-free.
While an IRA has a much lower ceiling in terms of annual contributions, there are a few significant advantages that make it attractive as a savings vehicle for young professionals. For one, a 401(k)both traditional and Rothrequires that the account holder begin making distributions when he or she reaches 70 1/2, while a Roth IRA is free of any distribution requirements.
Although the distribution requirement is fine for people who need this money anyway, it can prove inconvenient for people who are financially secure through inheritance or other means and don't really need to tap into their employer-sponsored account for retirement savings.
"My clients who have wealth outside the 401(k) get upset with the minimum distribution requirements," Napolitano says. "If you don't need the money, you're going regret having to take it out and pay taxes on it."
Napolitano notes that if you aren't going to need the money in retirement, it can be put into a Roth IRAeither directly or by rolling over your 401(k)and be left there. Looking down the road, you can then change the beneficiary to your spouse at death (who will keep the same terms) or to a non-spouse like a child (who will eventually be required to take distributions).
There are two other significant differences between a Roth IRA and the 401(k) options. First off, with a Roth IRA, you can take distributions at any point without incurring penaltieswhich could be necessary during emergencies or unemploymentwhile a 401(k) will impose penalties for distributions before retirement. Finally, a person will face considerable more fees with a 401(k) than a Roth IRA.
Gordon Bernhardt, president and CEO at Bernhardt Wealth Management in McLean, Va. says he always advises Gen X and Y professionals to fund their employer-sponsored plan before they fund a Roth IRA in order to take advantage of the employer match. Once they've accumulated multiple 401(k) plans in their career, however, he encourages them to roll them over into a Roth IRA.
"Many employer plans are very costly, and they can eliminate 1% or more of expenses if they move from a 401(k) to a Roth IRA," Bernhardt says.
He adds that costs should always be a forefront consideration for employees when it comes to the performance of their retirement savingsnot just in terms of the savings vehicle being used, but also the investments they choose. Additionally, Bernhardt encourages young professionals to begin saving 10% of their annual income as soon as it is feasible.
Meanwhile, McGrath emphasizes the importance of tax diversification when it comes to retirement savings. This can mean putting some money in a 401(k) and some in a Roth IRA so that you take advantage of immediate tax benefits on some of your savings and also tax benefits down the road on distributions.
"A lot of younger folks put all of their savings into a 401(k), which is fully taxable when they pull it out and who knows what the rate will be 30 years from now," McGrath says. "You should have different buckets of money so you have that tax diversification."
--Written by Paul Menchaca for MainStreet