Best bet for young investors: Roth, 401(k) or IRA?

@Money April 11, 2012: 6:35 AM ET

(MONEY Magazine) -- I'm 25 years old and contribute enough to my 401(k) to take full advantage of my employer's matching funds. But I can afford to save even more. My question: Should I just put more in my 401(k) or contribute to an IRA? -- Derek

Clearly, you always want to contribute enough to your 401(k) to get all the matching funds your employer is willing to kick in. Otherwise you're giving away free money.

But since you're already maxing out the match, your next best step is to go with an IRA, specifically a Roth IRA. And if you move quickly, you could sock away a healthy amount this year.

Fund a Roth IRA account by the April 17 tax filing deadline and you can invest as much as $5,000 and have it count as your contribution for the 2011 tax year. That would allow you to contribute up to $5,000 for the 2012 tax year, too.

If you decide to go the 401(k) route instead, the extra contribution will count toward the 2012 tax year, as you can't retroactively contribute money to a 401(k).

By contributing to the Roth IRA for 2011 rather than boosting the amount you put into your 401(k), you get a chance to put an extra year's contribution into your retirement kitty.

To make an annual Roth IRA contribution, you must first meet the income eligibility criteria. But even if you earn too much to do a Roth, you can still fund a Roth account in a roundabout way: Contribute to a nondeductible IRA and then convert that account to a Roth IRA. Before you try this end run, however, you should know that it involves a few wrinkles.

Why do I recommend you put money into the Roth rather than continue to save without a match in your 401(k), or for that matter contribute to a traditional deductible IRA, which you could also do for the 2011 tax year?

Two reasons.

First, although you don't get the same immediate tax-break with a Roth that you do with a 401(k) or traditional IRA, the Roth allows you to withdraw money down the road without paying a cent in income taxes as long as you meet the requirements for tax-free withdrawals.

The option of paying taxes on your contribution now is generally a better deal than getting a tax break today if you expect to be in the same or higher tax bracket when you withdraw the money -- often the case if you contribute when you're young and in a lower tax bracket.

Of course, forecasting the tax rate you'll pay years from now is an iffy proposition at best. Not only is it difficult to project what your taxable income may be decades ahead, it's even harder to predict the tax rates Congress might set.

That leads me to the second reason a Roth IRA is a good idea if you're already saving in a 401(k) -- namely, contributing to a Roth allows you to practice "tax diversification."

Since the savings you accumulate in 401(k)s and traditional IRAs will eventually be taxed at ordinary income rates when you withdrawal, a boost in tax rates during retirement could dramatically reduce the after-tax value of those savings. To the extent you keep some of your nest egg in a Roth account, you can protect yourself against the risk of higher rates.

Diversifying your tax exposure also gives you greater flexibility in managing your tax bill in retirement. If additional withdrawals from your 401(k) or IRA are about to push you into a higher tax bracket in a given year, you can take money from your Roth account instead and avoid the higher levy.

Roth IRAs offer other benefits. Unlike a traditional IRA, you're not required to begin withdrawing money from your account after age 70 ½. When you do pull money from a Roth, the withdrawals don't count in determining whether your Social Security benefits are taxable, as it is with withdrawals from a traditional IRA or 401(k). And if you decide you don't need to spend the dough in your Roth, you can pass it along to your heirs income tax free.

There is a downside to your plan of supplementing your 401(k) with a Roth IRA. And that's failing to follow through on it.

If you decide to increase your 401(k) contribution, all you've got to do is notify your plan administrator or HR department. The extra dough will be deducted from your paycheck automatically, assuring the money actually gets saved.

A Roth IRA requires more of a commitment. You've got to set up an account with a mutual fund company or other investment firm, and you must fund it. Neither is difficult. In fact, you can do the entire process online at many firms.

But with all the details that demand our attention in life, this is a simple task we sometimes never get around to completing. Next thing you know, the deadline has passed, and that extra savings didn't make it into a 401(k) or a Roth IRA.

So if you agree with my reasoning about a Roth IRA, I suggest you open and fund your account well within the April 17 deadline for a 2011 contribution. Once you've done that, you might as well get a head start for 2012 as well -- provided you'll also contribute enough to your 401(k) to get the maximum match.

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