To my friend Derek,

It may have seemed that a 401k was a good way to save and invest up to retirement upon the slow retirement of the pension option in both the private and public sectors. However, with today’s ever-changing economy and many young adults changing jobs more often than historically recorded, an IRA seems to be the best option at the moment that could help line our financial goals our other aspects of life (personal and professional). The one key advantage to a 401k is the employer contributions part, but this aspect is continuously decreasing in the percentage an employer contributes and at times can be nonexistent. Why and when should you pick a 401k over IRA?

  1. Employer contribution
  2. Plan on staying with an employer for a prolonged period of time (minimum 15 years)
  3. You don’t really have to worry about making your own portfolio, instead you can have so called “professionals” decide for you based on the amount of risk you’re willing to take and the amount of time you have till retirement.

Even with these positives, a 401k doesn’t make sense for young adults. Here’s why you should pick an IRA over a 401k:

  1. IRAs have lower structured fee cost than a 401k
  2. Though in an IRA you can pick make your own portfolio, you are often better off investing in a S&P 500 index than trusting the whims of people who claim to be stock picking experts (See Warren Buffets bet with hedge fund managers over a decade).
  3. You can changing you lifestyle and employers based on your needs and wants and still keep and continue to invest in your IRA without having to roll anything over or pay fees for accounts you no longer add money to/ see value in.

Now that we’ve established that an IRA is the better option for most young adults, which one should you pick? This rest of this article will focus on a young adult with an average financial literacy. Of course, if you are somewhat presupposed with the terminology and mechanisms of basic finance, you should able to make a financial plan based on your own needs and desires. But this article is not meant for those who are considered financial professionals, but rather for those who are young adult and those who like to focus on other professions that is of interest to them but not relating to finance. It is meant for those who do not wish let the worry about their retirement get in the way of their pursuits. These young adults can just follow the advice mentioned below and peacefully know that they’ll be okay in the future.

  1. Fact: S&P 500 index consistently provides an average return which is mathematically better than 50% of those are active stock pickers. To my understanding, the S&P 500 index beats out most professional investors in the long run (10+ years) with few exceptions (Pretend that you are not the exception). A good mutual fund that tracks the S&P 500 index is Vanguards VOO.
  2. Fact: The best way to get the most out of an average return is to invest averagely. This means that do not put your money anywhere all at once, instead buy over time. This method is called dollar-cost averaging. You are better off pre-planing certain days of the year to buy regardless of market conditions. This way you can get an average return despite buying at the “top” or the “bottom” of a market. Key note: market top or market bottom are speculative terms but I used them here to better communicate the meaning behind my explanations. The proper terminologies might be to ask if prices are sound or not.

To maximize return on investment:

This math is a bit complicated but I will explain the mechanics without using any mathematics at all:

If there was no limit on an IRA: the traditional is better because you can re-invest the tax deducted, which over time would compound at a much greater amount than the taxes you end up paying when it comes time to retire.

But, this world is not ideal. Do not get lost in the beauty: math is beautiful, but beauty is not always true.

For the following calculations, I will be assuming that a young adults invests the maximum amount allowed on an IRA per annum: $6,000. 

The US government caps the IRA amount to $6,000 per year. This disproves the beauty of the math on the compounding effect.

What I’m trying to say is that because of this $6,000 limit, a young adult is better off having a ROTH IRA because they can save a lot of money on taxes due retirement. This is true because with a traditional IRA you can’t re-invest $6,000 into the IRA due to the government limit, so that deductibility loses its importance. That leaves us with the ROTH IRA where you can fully invest $6,000 and just pay annual income taxes when you’re young, but when you retire you don’t have to pay as much taxes from the money you pull out of your ROTH IRA and are left over with more money in your pocket than you would have with a traditional IRA.

Here’s the difference:

Traditional IRA: Get IRA investment deducted from income when you’re young, but pay income taxes when you’re retired and pull money out of your traditional IRA.

ROTH IRA: Pay regular income taxes when you’re young and invest in the ROTH IRA out of your own money, but dodge income taxes when you try to take money out of your ROTH IRA due retirement.

I say that ROTH IRA is better than traditional IRA for two reasons:

1. The $6,000 yearly limit

2. Income taxes are always greater than capital gains taxes.

These are the two reasons why a ROTH IRA leaves a young adult with more money at retirement which is why I’m suggesting it to a person with average financial literacy.

Of course there are many more types IRAs and methods to save for retirement but the ROTH IRA is the best option for young adults who do not want to worry about retirement and thus focus on their own pursuits.