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What’s the Best Retirement Plan for Millennials?

Maurie Backman, The Motley Fool

If you're a millennial, then you have one major advantage when it comes to saving for retirement: time. Having a good 30 to 40 years in which to accumulate wealth could put you in a strong position to retire quite comfortably. The question is: Where should you house your savings?

While you may be inclined to stick your money in a regular old savings account, don't do it. That's a fine spot for your emergency fund, but what you really need is a tax-advantaged retirement account, like an IRA or 401(k), to help your money grow. This way, you'll get to fund your retirement plan with tax-free money and you won't pay tax on investment gains until you're ready to take withdrawals. At the same time, you'll need to devise an investment strategy that helps you make the most of your efforts -- and that generally means focusing on the stock market.

Young adults sitting around a table giving one of them a gift.

IMAGE SOURCE: GETTY IMAGES.

IRAs versus 401(k)s

If you're aiming to save for the future, then it's crucial to find the best home for your nest egg, which generally means choosing between an IRA and a 401(k) plan. Of course, not everybody has access to the latter, but anyone with earned income can fund the former.

The primary difference between IRAs and 401(k)s has to do with contribution limits. Currently, workers under 50 can contribute up to $5,500 annually to an IRA and $18,500 to a 401(k). Otherwise, both plans work similarly and come in the traditional and Roth variety. Traditional IRAs and 401(k)s are funded with pre-tax dollars and withdrawals are taxed in retirement. Roth IRAs and 401(k)s are funded with after-tax dollars and therefore don't offer the same instant gratification, but down the line, withdrawals are taken tax-free.

With both account types, you won't pay taxes on gains from investments year after year. Rather, traditional IRAs and 401(k)s grow on a tax-deferred basis, while growth in either type of Roth account is completely tax-free.

It's for this reason that IRAs and 401(k)s are preferable to regular savings accounts or traditional brokerage accounts. Savings accounts offer minimal growth potential, since your earnings are limited to whatever interest rates banks are offering. Additionally, the interest you earn on a savings account is taxed year after year. Traditional brokerage accounts offer the potential for high returns just like IRAs and 401(k)s, only without any of the tax benefits. Therefore, if you're starting out on your retirement savings journey, you're better off choosing between an IRA and 401(k).

Which of the two is better? Contribution limits aside, there are other nuances that give IRAs and 401(k)s advantages over each other. IRAs, for example, tend to offer a wider range of investment choices than 401(k)s, which can help keep your fees to a minimum, thus maximizing the growth of your savings. But when you save in a 401(k), there's the potential for free money if your employer offers a match. Ultimately, both accounts can help you reach your savings goals if you start contributing at an early age and invest your money wisely.

Investing your money

You may have heard that you'll need somewhere in the ballpark of $1 million to retire comfortably. The truth is that there's no magic retirement savings number to aim for. If you're willing to lead a modest lifestyle when you're older, you might easily get by on less than $1 million. On the other hand, if your retirement plans include extensive travel and nights out on the town, then $1 million may not cut it. Of course, at this stage in life, it's hard to develop a picture of what retirement looks like, but here's one thing you should know: There's no such thing as having too much money during your senior years, so the more you're able to accumulate, the better.

How do you go from just starting out to amassing a healthy nest egg? It's simple: You make modest, consistent contributions over time and invest that money somewhere that's been shown to produce results: the stock market.

Though the stock market has certainly seen its share of ups and downs, historically, investors in it have come out ahead. So let's assume you're 40 years away from retirement and are willing to invest the majority of your savings in stocks. Here's what your nest egg might grow to if your portfolio delivers an average annual 7% return, which is actually a few points below the stock market's average:

Monthly Savings Amount

Total Accumulated Over 40 Years (Assumes a 7% Average Annual Return)

$200

$479,000

$300

$719,000

$400

$958,000

$500

$1.2 million

$600

$1.4 million

TABLE AND CALCULATIONS BY AUTHOR.

Remember that $1 million savings target we talked about? As you can see, all it really takes is a $400-$500 monthly contribution and a stock-focused portfolio to get there. And if you put that money in an IRA or 401(k), you won't pay taxes on gains year after year, which means you'll get to reinvest your profits and grow your wealth even more.

As a millennial, you have a real opportunity to build a nest egg that'll buy you the retirement of your dreams. Whether you choose to house your savings in an IRA or 401(k), know that by going either route, you'll be doing your part to secure your future and possibly enjoy some neat tax breaks along the way.

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