Dear Dr. Don,
I am 26 years old, saving about $200 a month through a
401(k) and a Roth IRA. I consider myself a pretty disciplined saver, but I feel I am “pigeon-holing” all of my money for retirement instead of using it for other things I might want to do earlier in life.

My parents have a net worth of about $6 million. While I expect they will use a lot of this money before they die, I can reliably expect to receive a substantial inheritance before I reach retirement age. I would prefer to save money outside of retirement accounts because I plan to pursue other interests before age 59 ½ such as a Ph.D. degree, charity work or a few years out of the work force on sabbatical. What are the consequences of following this course of action versus saving only for retirement?

— Alex Accumulate

Dear Alex,
You make an important point about working toward financial and life goals other than retirement. For many twentysomethings, a Roth IRA does double duty for both short-term and long-term goals because it allows for distributions for qualified education expenses and first-time purchases of a home.

401(k) plan doesn’t have that kind of flexibility, typically only allowing for hardship withdrawals in special circumstances or plan loans that become due and payable when you leave the employer. A
401(k) can, however, be rolled into an IRA rollover account when you leave a job, which would give you the IRA’s measure of flexibility for education expenses or a first-time home buyer provision. See
IRS Publication 590 (2005) Individual Retirement Arrangements (IRAs) for more about early distributions from Roth or traditional IRAs. If your employer is matching all or part of your
401(k) contributions, you should contribute to the plan at least up to the limit of the match.

The benefit of saving for retirement in your 20s is that the money can be invested for 34 years until retirement, making it that much easier to reach your retirement goals. Your Roth IRA money will grow tax free until retirement, and qualified distributions out of that account will be free of federal income tax. That’s hard to beat. Since Roth contributions are made with after-tax dollars, there’s no tax due on withdrawals of contributed funds made prior to retirement. Any taxes due, and potential penalty taxes, relate to the withdrawal of investment earnings, not contributions into the account.

The advantage of investing in taxable accounts rather than tax-advantaged accounts such as a traditional IRA or a
401(k) plan is that long-term capital gains and dividend income are currently taxed at lower rates than the ordinary income tax rate due on money being distributed out of a tax deferred retirement account. Also there’s no pesky “penalty tax,” regardless of the reason for cashing out these investments. Take a sabbatical in Tibet, and you can fund it without paying a penalty tax by cashing in investments from your taxable account.

Barring any family rifts, remarriages or your parents buying an RV with a bumper sticker that says, “We’re out spending our children’s inheritance,” it’s reasonable to expect to be the beneficiary of some of their wealth. When that might happen and for how much is a mystery. I don’t think you should count on an inheritance to fund your retirement.

The best answer is to mix it up a little bit. You can manage your tax-advantaged retirement accounts to accomplish life goals other than retirement, and you can manage taxable investment accounts to accomplish life goals including retirement. Give yourself a little financial flexibility in both arenas.

Evaluate which life goals are going to require cash to accomplish and which won’t, and plan accordingly. Graduate assistantships, scholarships and student loans can always get you though graduate school. A sabbatical from teaching might be at half salary. Your short-term needs for cash may be less than you think, and pushing retirement savings to one side isn’t necessarily the best approach to reaching your life goals.