Among priorities with shorter timelines (car repairs, paying down debt, etc.), one of the first responsibilities recent college graduates have upon landing a job is to begin setting aside a little money for retirement. If one notion has become apparent over the past few years, it’s that Gen Y will not be receiving anywhere near the social security, defined benefit contributions or retiree healthcare many of our grandparents have access to. Not only will we be shouldering an increased tax burden to help current and near retirees, but we’re going to be responsible for providing a higher percentage of our retirement dollars.
In my view, the smart way to do this is not through increased risk on the investment side, but rather through using the effect of compound interest and creating a diversified, buy-and-hold investment strategy. In terms of diversification, most college grads with a corporate job will have a 401k plan, presumably with some level of company match. In almost all cases, the first order of business should be to contribute enough to receive the maximum company match.
Personally, I’m in the camp of maxing out a Roth IRA after meeting these guidelines for several reasons. Since Roth contributions are made with after tax dollars, your money grows tax free. If a Gen Y employee were to contribute $5K (roughly $400 per month) every month to a Roth IRA from age 25-65, that would grow to over $1 million tax-free dollars (assuming a 7% return) at the end of forty years. Pretty cool! Secondly, unlike most 401k’s, Roth’s can easily be invested in a variety of investments. While some people will not care about this and use a Target Date fund, those who want to slice-and-dice their portfolios among a variety of asset classes will most likely be disappointed in their ability to do this cost effectively within a 401k.
Thirdly, since Roth money is contributed with after tax dollars, it can be accessed without a penalty such is the case in most instances with a 401k. For younger employees with fewer assets, that’s definitely a nice to have from a comfort level perspective. Lastly, employees who invest in both a traditional 401k and Roth IRA receive tax diversification. If for instance, an employee were to have a $2 million portfolio at retirement ($1 million in 401k and $1 million in a Roth IRA ), half of that money would be taxable and half would be not. Also, this employee would not have to take RMD (Required Minimum Distribution) on the Roth dollars, which can be a significant benefit depending on one’s circumstances.
For Gen Y (or Gen X, Baby Boomer) employees who are able to contribute more to their retirement than a minimum 401k contribution, a Roth IRA is a great way to receive tax diversification and help save for retirement.
