Extra savings: Stick 'em in a Roth

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NEW YORK (Money) -- Question: I'm 24 and my employer matches up to 5 percent of my salary in my 401(k) plan. If I want to save, say, 8 percent of my salary, would I be better off putting it all in the 401(k), or limiting my 401(k) contribution to 5 percent of pay and putting the rest in a Roth IRA? -Dave Meyer, Corpus Christi, Texas

Answer: First, let me congratulate you for getting off to such a great start with your retirement planning. With you kicking in 5 percent of your salary and your employer matching it, you're socking away 10 percent a year right there, which is terrific foundation for anyone just beginning his or her career.

But as I pointed out in a column last year, the "10 percent" rule that we hear bandied about so often as the savings standard for prudent retirement planning hardly guarantees that you'll end up with enough to live comfortably after you call it a career.

That's especially true when you consider that traditional check-a-month pensions are rapidly becoming anachronisms and that the value of the Social Security benefits someone your age will eventually collect is a big question mark.

So you're right to want to sock away another 3 percent of your salary, if not more. The question is where should you put it? I don't think there's any "wrong" choice here. The mere fact that you're getting such an early start dramatically increases your chances of achieving a comfortable retirement regardless of which accounts you choose to fund.

That said, however, I think there's a more compelling case for plowing the extra 3 percent into a Roth IRA, assuming you meet the eligibility criteria. (For details on those requirements as well as information on the contribution limits for Roth IRAs, click here.)

A young person like you just starting out is likely to earn more money and move into higher and higher tax brackets as you gain experience and earn promotions. If you have a good career and save diligently, it's not a stretch to imagine that you could end up facing a higher tax rate in retirement than you do right now.

That's an ideal situation for a Roth IRA. The reason is that you contribute after-tax dollars to a Roth in return for getting tax-free withdrawals in retirement, so you would end up paying tax at a lower rate today and avoiding tax when you face a higher rate in retirement.

With a 401(k), by contrast, you invest pretax dollars today and pay tax when you withdraw the money. That makes the 401(k) generally a better deal if you fall into a lower tax bracket in retirement, since you would be avoiding taxes at a higher rate and paying them when you're in a lower tax bracket after you retire.

Of course, it's hard to tell what tax rate you'll face in retirement, especially when that retirement is 40 or more years away, as it's likely to be in your case. Which is why I think it's a good idea for most people to have money in both tax-deferred accounts like 401(k)s and traditional deductible IRAs as well as in tax-free accounts like a Roth IRA and Roth 401(k). (For my take on Roth 401(k)s specifically,click here.)

By contributing 5 percent of your salary to your 401(k) and reaping the 5 percent employer match, you've clearly got the tax-deferred part of your retirement savings covered. So as I see it, by putting that extra 3 percent into a Roth IRA you'll be able to simultaneously build the tax-free part of your nest egg, thus allowing you to diversify your tax exposure in retirement. (As you progress in your career, you can diversify that exposure even more by funding investments that generate gains that are taxed at the favorable long-term capital gains rate.)

For details on how to practice this sort of "tax diversification," click here. If you do decide to funnel your extra savings into a Roth IRA, it's crucial that you actually follow through. Funding a 401(k) is pretty simple. You just sign up and your employer automatically deducts your contributions. But you have to make sure your money gets from your paycheck to your Roth IRA. If you're not sure you'll make that happen, I'd recommend you just throw the extra 3 percent into your 401(k).

One way to replicate the convenience of contributing to a 401(k) is to arrange for money to be transferred automatically from your checking account to your Roth IRA account each month. Virtually all mutual fund companies offer such automatic investing plans, with some allowing you to start with contributions of $100 a month or less.

You can see whether a fund offers an automatic investing plan and, if so, check the required minimum investment by plugging the fund's name or ticker symbol into the "Quotes" box at Morningstar.com and then clicking on the "Purchase Info" link on the fund's Snapshot page.

One final note: as big an advantage as an early start provides, it's still possible to run into setbacks along the road to retirement. So you'll want to check your progress along the way. For details on how to do that and advice on ways to revise your retirement strategy if necessary, I recommend you check out the "Do It Now: Are You On Track for Retirement" section of our site.

But if you continue to display the same commitment to saving for retirement that you're showing now, I suspect that these occasional updates will bring mostly good news.