Sometimes it’s good to get back to the basics. I often get asked whether it’s best for folks to stash their retirement money in a 401(k) or a Roth IRA. Like most things in life, there is no “one size fits all” when it comes to saving for retirement. However, below is a general rule of thumb.
Here’s my primer on these powerful tax-advantaged savings vehicles and the benefits of each.
What’s a 401(k) Plan?
Simply put, a 401(k) is an employer-sponsored retirement program that lets you invest your pretax pay into the plan. Sometimes employers will offer to match a portion of your contributions, thus sweetening the deal. Your savings grow tax-free until you start making withdrawals during retirement, at which point you will pay income tax. Still, the tax piece of 401(k)s is pretty sweet – your money grows without incurring a tax bill, and the year-end income tax bill on your is lowered because your contributions reduce your taxable salary. For example, if you earn $50,000 and contribute $5,000 to your plan, then you’ll only owe tax on $45,000 as $5,000 is contributed “pretax”. See what I mean?
What’s a Roth IRA?
A Roth IRA is a different flavor of the traditional variety. Remember that with a traditional IRA you contribute pretax dollars. With a Roth IRA, however, you’re contributing money to the plan that has already been taxed, or after-tax. Now, this may sound like a bummer, but the advantage it that your earnings don’t get taxed. And the best part? Neither will your withdrawals when you hit retirement age. Hence why this type of plan is also considered a tax-advantaged savings vehicle.
Which One Is Best for Me?
While your savings situation is unique, in a perfect world, you would be contributing to both a 401(k) and Roth IRA. After all, the more you invest in your retirement savings plans, the more income you’ll have once you call it a career.
But if you must choose between the two, a general rule of thumb is to contribute to the 401(k) first. It is generally a good idea to focus on trying to contribute up to your employer’s match. Say your employer will match 50% of your money up to 6% of your pay. Then you should work towards putting in at least 6%, so you earn that extra 3%. That, folks, is what we call free money, and we all know not to turn that down.
After contributing up to the employer’s match, if you have additional funds to invest, we generally suggest funding a Roth IRA. As we said above, you’ll have paid taxes on the money you invest, but you won’t have to pay taxes on the money again. Ever.
The younger you are, the more attractive this vehicle is. If you start contributing when you’re in your 30s, for example, by the time you’re ready to retire you should have stashed (and grown) a healthy sum. Of course, during the same time, your 401(k) is growing, too. Again, win-win.
So, what do you do once you have your 401(k) maxed to the match and are making the maximum contributions to a Roth IRA? The general answer is to go back to your 401(k) and contribute even more. Not only will you save even more on your tax bills at year-end, but you’ll be growing a tax-free nest egg even faster.
As always, your particular needs and goals may vary. My one piece of advice that I would carve into stone is to talk to a qualified financial planner. These professionals can help you chart a course that works best for you and keep you on track for years down the road. You don’t have to go it alone, and when in doubt, let a professional help you make the best decisions for you.