Saving: Roth IRA's vs. 401(k)'s

I have this friend who is so proud of herself these days. Beth told a group of us that she opened up an ING online savings account and put all her savings there which will earn more than triple what her checking account earns. After the oooh's and ahhh's subsided, the bubble-burster in me went in for the kill.

"So this is money you saved on top of your Roth IRA contribution?" Her clueless facial expression showed that she had no idea what I was talking about. She clearly had an old-fashioned conception of what it means to save.

After all, saving isn't any good unless you're saving money in a smart, savvy way.

A lot of the strategies for smart saving involve ways to lighten your tax burden. For many young people working today, their employer offers some sort of retirement savings plan -- for most of us, it's a 401(k). But the government has essentially created a huge tax loophole for people making less than $114,000: the Roth IRA.

Again, I'll refer you to my original post about the person figuring out how to pay of debt and save for a potential first home purchase. While his intention to open a money market savings account to accumulate money for a downpayment is good, he's not necessarily using the right mechanism.

After making sure you have a bit of emergency cash (for a natural disaster, Apocalypse, etc.), you should enroll in your employer's 410(k) program, especially if your employer "matches" your contributions. These matching programs reduce your tax burden AND give you extra compensation from your employer. Money that you put into your 401(k) will go in "pre-tax."

The disadvantage of a 401(k) is you won't be able to touch the money for a long time, and there are substantial penalties for doing so. When you withdraw, you'll also have to pay income tax on the proceeds.

A Roth IRA works a bit differently. Most of you will be able to contribute $4,000 this year. Your contributions come after taxes, and usually Roth IRA's have nothing to do with your employer. The beauty of the Roth is that all earnings are tax-free, and there a lot of circumstances that allow penalty-free early withdrawals (for example, you are always allowed to withdraw your contributions with no penalty.)

Other circumstances for penalty-free withdrawals from a Roth IRA include a first-home purchase, health expenses, and tuition.

For the vast majority of you, here's a quick list of how to allocate your savings:

1) Get the most out of your employer.
First, max out on your 401(k) contribution to the point where your employer "matches"

2) Take advantage of a Roth IRA.
After contributing enough to get the full employer matching funds, max out on your Roth IRA contribution for the year.

3) Save in taxes.
Contribute more to your 401(k) until you reach the employer or legal limit. Remember, you won't be able to touch most of this money for a while. If you're not willing to put it aside, you should be prepared to pay taxes on this amount and put it to good use.

In future posts, I'll offer some more details on how and when to start a Roth IRA.