I’m in my 20s and I’m just getting started in the working world.  My employer has a 401(k) with the attached list of investment choices. I’m also looking at a Roth IRA. Is there a certain Roth you recommend? Which of the 401(k) investment choices do you recommend?

I have been reading some of your articles on your website and saw that you started your kids Roth contributions at age 14, so you might have a favorite you’ve been working with for a while now. I would love to start funding my Roth and 401(k,) but I have no idea where to begin! Any advice would be appreciated.

Amy Lee

Greetings Amy Lee,

Great questions! I would be glad to help. I’m going to answer your questions in three separate blogs posts this week:

1. Which investments should I fund first?

2. Which of these 401(k) investment choices do you recommend?

3. Is there a certain Roth IRA you recommend?

WHICH INVESTMENTS SHOULD I FUND FIRST?

Here is the order I recommend someone in their 20s start investing:

1. Money in your 401(k) only up to what is required to get any employer match. Every company’s 401(k) is unique. Often you have to be employed for a year before you can participate in a company’s 401(k). For a generous employer this might mean contributing 5% of your salary and getting a 4% match from your employer. The value of an instant 80% return on your money is too good to pass up even if your company’s 401(k) plan is laden with fees and expenses. When you leave employment, you will be able to take everything you put in and any company contributions which are vested. Make sure you know at what rate the company portion vests so that you aren’t surprised when you leave employment.

If your employer has a match, ask if they allow a self-directed 401(k). This will lower your fees and increase your choices. Also ask if they allow you to put your contributions into a Roth 401(k). This is also advisable for most younger employees.

2. Roth IRA up to the $5,000 maximum ($6,000 for those 50 years and older). If you are in your 20s, you will never pay as little in taxes as you do right now. Therefore rather than putting money into a traditional Roth or 401(k), you should pay what little tax you pay, and then put the money someplace where it will never be taxes again: A Roth IRA.

Warren Buffet makes a great deal about how his tax rate is only 15% because most of what he has to report as income isn’t really income. It is capital gains. In truth, it has already been taxed at the corporate rate, and then a good percentage of it is just inflation anyway. The tax rate on capital gains ought to be zero, and the only place you can find that rate is in a Roth IRA.

Money contributed to a Roth IRA can be withdrawn so long as the account has been open at least five years. Appreciation must wait until you turn 59 1/2. Therefore you can store savings up in your Roth and still get to it later if needed.

3. Taxable investment account. After getting any 401(k) match and fully funding your Roth, I would fund a regular taxable investment account next. Your tax rate is low, and you should probably not worry about getting a tax deduction at your low rates only to pay at a higher rate in retirement when you have made your fortune. Just the fact that you are thinking about investments in your youth puts you in the top 5% of potential wealth builders. Put the money into a taxable investment account.

4. You could fund your 401(k) even if there isn’t a match. If your wages are extremely high, this choice might move up to #3. But just the fact that you are in your 20s leads me to believe that your tax rate will be higher in the future. Therefore I don’t think I would use this option, I would just keep increasing the amount your put in #3, a regular taxable investment account.

In summary, if your annual pay is $50,000 a year, you might put $2,500 (5%) into the 401(k). Your employer might match with $2,000 (4%). You might put an additional $5,000 into a Roth IRA (10%). Finally, you might put an additional $2,500 (5%) into a taxable investment account. In this way you would be saving about $12,000 or 24% of your annual income. Your take home pay would be $40,000 since $2,000 of your savings would be paid by your employer.