While I was in New York a few weeks ago, I stopped by to meet Jonathan Clements, the former columnist for the Wall Street Journal — which I thought was the best personal-finance column in the country. (Here’s one of his columns: Twenty Tips for No-nonsense Investing.)
There’s no debate over the top priority. If you’re new to the work force, you ought to be funding your employer’s 401(k) plan, because it will give you a trio of benefits: an upfront tax deduction, tax-deferred growth and maybe a matching employer contribution.
But that brings us to the more interesting question. What should your no. 2 priority be? Forget building the six-month emergency reserve or saving for a house down payment. Instead, I would vote for funding a Roth IRA.
With a Roth, all your withdrawals once retired should be tax-free. True, unlike a regular IRA, a Roth won’t give you an initial tax deduction. But if you’ve just entered the work force and you are on a relatively low salary, that tax deduction probably isn’t worth all that much.
Meanwhile, here’s the sweetener: At any time, you can withdraw your original Roth contributions without triggering taxes and penalties. Let’s say you stash $5,000 in a Roth every year for four years. You could pull out your $20,000 in contributions and, provided you didn’t touch the account’s investment earnings, there shouldn’t be any taxes owed.
That means your Roth could double as your emergency reserve, your house down payment money, your car purchase fund or be used for any other purpose. (There is another provision that allows first-time homebuyers to make tax-free Roth withdrawals. To take advantage of this, the Roth has to be open five years and the amount is limited to $10,000.)
Ideally, you would leave your Roth to grow untouched until retirement. That way, you’ll get the most out of the tax-free growth. But if you
need it, the Roth offers wonderful financial flexibility. To learn more, head to www.fairmark.com.
I’ve written about Roth IRAs and 401(k)s in The World’s Easiest Guide to Retirement Accounts.