retirement

Build an Emergency Fund or Invest for Retirement?

Our reader has the enviable problem of saving so much he doesn't know what to do with it all. We help him prioritize.

OUR READERWho: Ian MacKinnon, 26Where: Philadelphia

Question: What should I do with the $25,000 in my savings account?

Four years after landing an engineering job with Sunoco, Ian, 26, is eager to make his savings work for him. By living frugally, the former college athlete has kept himself in solid fiscal shape. He's paid off his student loans and amassed $25,000 in a savings account. Ian also contributes 15% to 20% of his paycheck to his company's 401(k) and qualifies for his employer's 5% match.

Despite this cushion, Ian says his strategy needs a jolt. He insists that at least $10,000 remain in the bank, but he's eager to earn higher returns on the rest of his money. Still, he doesn't want to put all of the remaining $15,000 at risk, he says. "You never know -- I might want some of it available in case of an emergency." Ian sees three possible major expenses in his future: a new car, a house and graduate-school tuition. But he doesn't expect to take on any of those obligations in the next five years. One reason he's not in a hurry to buy a place is his job, which has him rotate among various locations (he recently moved from Tennessee to Pennsylvania to take up new duties).

Filling the Gap

Ian's financial start puts him ahead of many -- if not most -- of his peers. But his story is also a reminder that there's a long, long time between the first job and the last one. Financial planners say it's easy but wrong to overemphasize retirement savings when you're unlikely to be retired for a few decades.

Timothy Maurer, vice-president of the Financial Consulate, in Hunt Valley, Md., says that Ian "deserves a pretty substantial affirmation because he's doing an outstanding job." But there is one problem: Maurer calls Ian's current strategy a barbell scenario. That means he's heavy on the two extreme ends -- short-term emergency cash and retirement savings -- but has left a gap in the middle.

Maurer recommends Ian fill the void by divvying up his resources into fourths. Because he already has the two ends covered, he can keep $10,000 in cash accounts that are easily accessible and divide the rest between a taxable brokerage account and a Roth IRA, to which he can contribute up to $5,000 in 2011. Unlike his 401(k) contributions, Ian's contributions to the Roth can be withdrawn at any time without taxes or penalties.

Meanwhile, growth-oriented mutual funds would be best for the brokerage account. Ian can feel comfortable seeking higher returns because he won't need to make withdrawals for many years.

Richard Salmen, a senior adviser with GTrust Financial Partners, of Topeka, Kan., recommends that when Ian chooses mutual funds, he should make sure that the new funds' objectives are in harmony with his 401(k) and compensate for any gaps. A basic fund such as Vanguard Total Stock Market Index Fund (symbol VTSMX) or Vanguard Total Bond Market Index Fund (VBMFX) should work well alongside just about any 401(k).

There is one thing that could upset Ian's apple cart, says Salmen -- a serious relationship. When a couple begins to think about commingling finances, he suggests that they first consult a financial adviser for a basic, if unromantic, chat.

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