Preparing for a baby: how should we save?

My wife and I are in our mid to late 20s and we are trying to determine what the next financial step for us should be. We do well financially, have saved 5% in 401(k)s since college, own a home in a good community, have an adequate emergency fund and carry very little debt besides our school loans. We feel like we are ahead of the curve but don't know what to do next.

What should we do with any savings we can squeeze out? We have only a small amount of equity in our home, should we make extra payments on the house? Should we open a Roth IRA? Sooner rather than later, we hope to start a family. What can we do now to provide for ourselves and a family in the future?

Sounds like you have a fantastic head start. You mention that you hope to start a family sooner rather than later - does that mean that one of you might be staying home with children? If yes, you might need a much larger emergency fund and perhaps a "supplemental income" fund -- a pool of money to replace some of what you will lose if one of you stops working for a few years or decides to work less hours. Even if you have prepared a budget and you think you can live on just one income, it is always a good idea to have some "just in case" money.

If you both plan to return to work after having a baby, my answer is still the same because the cost for infant daycare in our area is unbelievable. If you really think you will be having a baby in the next year or two, I'd direct your excess savings to your emergency account so that you have some flexibility.

Alternatively, if you are fortunate to have a relative nearby who will watch your baby for you, I'd direct your excess savings to your 401(k) or a Roth IRA. You have been saving 5 percent of your pay since college, but to really be in good shape for retirement, that figure should be closer to 10 or even 15 percent if you can manage it. I'd add the extra money to your 401(k) if you have not yet captured your full employer match. If you have captured the full match, I would suggest contributing to the Roth.

I like saving in Roths because the Roth is an incredible retirement savings tool. You don't get a tax deduction for contributing to a Roth, but all money withdrawn from a Roth in retirement is tax free (my two favorite words) and there are no required minimum distributions ever. Also, if you absolutely needed the money for a reason other than retirement, Roth IRAs have a unique feature: you are always allowed to withdraw your regular contributions at any time without a penalty and free from taxes.

Given your ages, you and your wife would each be able to contribute up to $5,000 to a Roth IRA this year.

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