A nest egg for early retirement

Saving early and often is the single most important thing you can do, says Money Magazine's Walter Updegrave.

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By Walter Updegrave, Money Magazine senior editor

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NEW YORK (Money) -- Question: I've been out of college a year and I want to be sure I'm on the right track to retire early. I currently contribute 5 percent of my salary to my 401(k), which is matched in full by my employer, plus I invest $200 a month in a stock fund. I just got a raise and am now trying to decide whether I should consider putting some of that money into an IRA or boost my investment in the stock fund. What do you suggest?

-Richard Stevens, Washington, D.C.

Answer: I just love it when I hear from someone your age who is already saving so diligently for retirement. Getting an early jump on saving gives anyone a huge edge in building a nest egg for retirement. But if you hope to call it a career in your 50s or early 60s, a good running start is virtually a requirement

Why? Well, the sooner you stop working, the fewer years you have to accumulate a decent retirement portfolio. And the earlier your exit from the workforce, the more years your savings have to carry you. That double-whammy - less time to save, more time for your money to last - is what makes turning the dream of early retirement into reality such a challenge.

But if you're willing to really work at it, you can meet that challenge. The question is how. Let's start with what you should do with that raise.

The first thing you need to do is check back with your 401(k) and make sure you're taking full advantage of the employer match. If you're not - that is, if your employer will kick in even more money if you contribute beyond 5 percent of salary - then you should stash as much of that raise into your 401(k) as you can until you're getting every cent of matching funds. Failing to do that is like turning up your nose at free money.

The company match

Once you're sure you're maximizing your company match, the next place to turn is to a Roth IRA. For the 2007 tax year, you can contribute up to $4,000 to a Roth, an amount that rises to $5,000 for the 2008 tax year. People 50 and older can throw in another $1,000 a year. (This assumes, of course, that you're eligible for a Roth, which you can find out by clicking here.)

Why go to the Roth rather than just automatically upping your contribution to your 401(k) without a match?

A couple of reasons. When you invest in a 401(k), you'll avoid tax today on your contribution, but pay it in the future. So a 401(k) is generally a better deal if you think you'll move into a lower tax bracket when you withdraw the money in retirement.

The opposite is the case with a Roth since you're paying the tax today (i.e., investing after-tax dollars) and avoiding it in the future. This means the Roth is usually a better deal than a traditional IRA if you'll be in a higher tax bracket when you withdraw the money. Since it's hard to tell what tax bracket you'll be in several decades from now, having money in both a Roth and a 401(k) allows you to hedge your bets a bit.

Early withdrawals

Another appealing feature of a Roth is that you can get at your Roth contributions (though not earnings on those contributions) at any time without paying the income tax or penalties that you may face on early withdrawals from a 401(k) or other tax-deferred account. That access can come in handy if you retire at a relatively young age.

By the way, if you don't qualify for a Roth, you may still be able to get into one by doing an end run around the Roth regulations as described here.

If after doing the Roth you still have some of your raise left, then I'd recommend that you continue plowing money into your 401(k) until you reach the contribution limit. You won't get matching funds, but you'll still get the advantage of investing pre-tax dollars that will generate earnings that won't be taxed until you withdraw them.

And if you still have money left after putting all you can into tax-advantaged savings plans, then you can move on to taxable accounts. (For tips on how to invest money in those accounts, click here.)

Indeed, as you progress in your career, you'll probably want to make it a point to have at least some money in taxable accounts. Why?

Tax exposure

Well, one reason is that taxable investments can further diversify your tax exposure. (For more on what I like to call "tax diversification," click here.)Another is that if you're really planning on an early exit from the workforce, you will likely want a pool of assets you can easily draw on early in retirement before you begin collecting Social Security and tapping tax-advantaged accounts.

Granted, there are ways to tap tax-advantaged accounts without incurring penalties. You can take advantageof the 72 (t) exemption, for example, and you can always withdraw your Roth IRA contributions without tax or penalty.

But you may want more cash than you can get penalty-free from tax-advantaged sources. So as a practical matter, it's nice to have some money in taxable accounts that you can get at without hassles or penalties.

Keep in mind too that as you follow this strategy of doing the 401(k) until you get the full match, then the Roth, then maxing out the 401(k) and then moving on to taxable accounts that you should also have an easy-to-tap reserve at hand in the event you need money for unanticipated expenses or emergencies.

A comfortable cushion

So before you start funneling all your savings into tax-advantaged retirement accounts that will be invested mostly in stock funds, you'll want to have three months' or so worth of living expenses in a secure place such as a taxable savings account, CDs or money-market fund. This will give you the ability to raise money quickly if necessary without having to disrupt the longer-term investments you've made for retirement.

One final note. Although saving early and often is the single most important thing you can do to increase your odds of retiring early, there are plenty of other matters you'll need to consider, especially as you approach your early-retirement date.

Here I'm thinking about topics such as how you'll spend your time in retirement, where you'll live and whether you'll want to continue to work in some way after leaving your career job. You can get more advice on these and other retirement issues by checking out two recent Money Magazine cover stories: "Retire Early" and "Retire Rich".

And if you continue to save and invest the way you do now, you should have an excellent chance of being able to do both. To top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.