Roth IRA can be 27-year-old's first step toward saving for retirement
Q: I am 27 and have a bit of money saved that I haven't touched for years. I'd like to grow it, but I'm not sure of the best way. Should I contribute to my 401(k), even though my company doesn't offer a match, or should I open an IRA? And is there a way to invest that will let me use the money before I retire? I don't want to have to live with roommates forever. — Danielle, New York City
A: First, congrats for building your savings — and for leaving the balance untouched. Your desire to grow the money is also a good one.
Most financial planners recommend having three to six months' worth of expenses in cash to cover emergencies. But for long-term goals, such as retirement, you will need to be more aggressive. Otherwise, your savings may not accrue quickly enough to meet your needs.
Consider: If you socked away $5,000 per year in a bank savings account and earned 1 percent, on average, annually, about the highest interest rate available today, your money would add up to little more than $240,000 in 40 years.
But if you invested the cash in a portfolio of stocks and bonds and earned 8 percent annualized, about the long-term average for such a portfolio, your money would grow to a far larger sum — more than $1 million.
So, where should you get started?
For retirement savings, planners normally suggest investing in low-cost stock and bond funds in a 401(k), contributing enough to get the full company match.
But because your employer doesn't offer a match, Paul Palazzo, a financial planner in New York City, said to open a Roth individual retirement account instead.
Roth IRAs offer tax breaks and flexibility. Earnings grow tax-free, and qualified withdrawals, including anything you take out starting at age 591/2, are also tax-free. What if you need the money sooner? You can tap contribution amounts (but not earnings) without penalty.
Currently, the maximum you can contribute per year to a Roth IRA is $5,500, depending on your income (the contribution amount phases out completely if you're single and have a modified adjusted gross income of $129,000 or more in 2014).
You have until April 15 to make a 2013 contribution, which means if you made the deadline, you could put away as much as $11,000 this year.
You can open a Roth at major investment shops such as TD Ameritrade and Vanguard. Once you've maxed out the Roth, you have a couple of options.
For one, you could direct extra savings to your company's 401(k). Even without a match, 401(k) plans have their advantages, Palazzo said.
Contributions are tax-deductible and earnings grow tax-free (withdrawals get taxed).
You can also save more. For 2014, the contribution limit is $17,500. And if you leave your job, you can roll over the money into an IRA.
A second option: Put cash you won't need for a few years in a taxable brokerage account. You don't get big tax breaks, but there are no contribution limits and you can access the money whenever you want.
"Saving in a taxable account is often ignored or downplayed, but I like it because you can use the savings to do things like start a business, care for children or buy a home," said Bonnie Ashby Sewell, a financial planner in Leesburg, Va.
Taxable accounts can be opened at major brokerages and mutual fund companies. In the account, Sewell recommends investing in a mix of low-cost index funds.
You're not guaranteed to get your principal back, as you would with a bank savings account. But a diversified portfolio should help lessen the effect of big market swings on your savings while still giving your money the fuel it needs to grow.
Carolyn Bigda writes Getting Started for the Chicago Tribune.