By now, you should be the proud owner of a convenient local checking account and an interest-bearing savings account that will keep your short-term and emergency funds safe from inflation. (if not, read my last post on Cash Flow accounts.)

We have only just scratched the surface. To really put your money to work, you will need to delve into the wide world of investment accounts!

Many different types of investment accounts exist to serve different purposes. As we’ve discussed, one of your fundamental goals must be saving adequately for retirement. Retirement will likely be 1) the biggest expense of your life and 2) the expense that you have the most time to prepare for, so retirement accounts is where we shall begin.

The government wants you to save for retirement, and has set up a number of benefits to make saving very attractive, especially for low-income twentysomethings with thirty-plus years to save. There are so many benefits, including juicy tax credits, to saving for retirement, that soon I will devote an entire series to retirement planning….but for now, let us take a close look at some of the special accounts that the government allows for holding retirement savings.

A wide variety of retirement account options exist, including 401(k) and 403(b) plans, Traditional and Roth IRAs, and a whole host of accounts designed specifically for small business owners. These accounts are all unique in that they have tax benefits, that is, if you meet certain requirements, you can use retirement accounts to defer or eliminate taxes due on the money that you save in and the earnings that come from retirement accounts.

Where should you begin?

Free money from your employer is not a bad place to start. If your company offers a 401(k) or 403(b) plan, you would do well to advantage of it. The major advantage of these employer based plans to a twentysomething is the “company match”, a percentage of your contributions to the plan that your company matches, dollar for dollar, on top of your regular salary. If your employer is willing to help you fund your retirement savings, please take advantage of it!

There are other advantages to employer-based plans, though in my opinion, the other advantages are less meaningful to a twentysomething. For example, 401(k) and 403(b) plans have comparatively high contributions limits ($15,000 per year as of 2006). For many of us, limits that high are almost meaningless in comparison to our often meager salaries - especially if you work for a non-profit or startup. There are tax advantages to employer-based plans as well, in that you contribute pre-tax dollars. That means that any money invested in such a plan is deducted from your income as reported to the IRS - thus reducing your tax burden. If are already in a relatively low tax bracket, this deduction is not as meaningful as it is to many older Americans. (You will have to pay taxes eventually; these accounts simply allow you to defer your taxes until retirement.)

In short, the company match is the greatest benefit to a 401(k) or 403(b) plan, and is reason enough to enroll in the plan, with some limitations.

If your company doesn’t offer a retirement plan, you could take advantage of similar tax benefits via a Traditional IRA - albeit without the company match and with significantly lower contribution limits.

For a twentysomething, there are two major disadvantages to 401(k), 403(b) and Traditional IRAs. First, if you need to withdraw those funds for some reason prior to age 59 1/2, you will not only pay tax on the withdrawal as income, but also a 10% penalty. Second, even if you wait until government-endorsed retirement (at age 59 1/2) to withdraw those funds, you’ll still pay tax on your withdrawals as ordinary income. These drawbacks are enough for me to shy away from these accounts, except to take advantage of company match dollars.

Consider this: since you are already planning for retirement in your twenties, there is a good chance that you will withdraw more annually from your retirement accounts in retirement than you earn now. Which means that you will pay more in taxes then on those same dollars than you would today - and that assumes that taxes stay at today’s rates. I would rather not count on tax rates dropping during our lifetimes. So unless you’re earning enough to take advantage of the higher contributions limits (and resultant tax breaks), enroll in your company’s 401(k) or 403(b) plan and set your contribution to the maximim amount that your employer will match - and not a penny more.* I do not recommend Traditional IRAs for most quarterlifers., so the remainder of your retirement savings will go into your Roth IRA.

The Roth IRA - absolutely the most perfect retirement account for a twentysomething. Why? With a Roth IRA, you contribute post-tax dollars, which means that your taxable income may be a bit higher, but when it comes time to withdraw those funds (at the ripe old age of 59 1/2) you will pay no tax. Nothing. Nada. Zilch. This feature makes Roth IRAs very attractive to me.

Furthermore, if you need those funds for any reason prior to retirement, you can withdraw any Roth contributions with no penalty. So in effect, a Roth IRA serves as a backup to your emergency savings. And like other IRAs, if you hold the account for at least five years, you can withdraw up to 10k in earnings without penalty to buy your first home, and you can withdraw earnings at any time with no penalty to pay for college expenses. Sound like a good deal? I think so too. There are estate planning advantages to Roth IRAs as well; icing on the cake for a twentysomething.

*Note: Your company may offer a new type of account, the Roth 401(k) http://www.roth401k.com/ which offers the best features of 401(k) plans and Roth IRAs. If so, I recommend you take full advantage of the company plan.

Coming up next: Where should you hold your Roth IRA?

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This entry was posted on Sunday, September 10th, 2006 at 8:13 pm and is filed under "The Plan", Retirement, Roth IRA. You may e-mail this post to a friend. You may print this page. You can leave a response, or trackback from your own site.