Should I fund my 401(k), Roth, or traditional IRA?
There are three types of retirement investment accounts for employees: 401(k), Roth IRA, and the traditional IRA.
If your employer offers a match to your 401(k) contributions, then your first priority should be to contribute enough to the 401(k) to maximize any employer match. For example, your employer may offer to match 50% of the first 6% of your salary that you contribute. If your salary is $50,000, and you contribute 6% ($3,000), your employer will match half, or $1,500, for a total of $4,500 in your retirement account. You don’t pay income tax now on either the contribution or the match, but you will when you take it out (plus any gains) during retirement. The idea is that you’ll then be in a lower tax bracket, so you save on taxes. (I’m not sure I believe we’ll be at a lower tax bracket in retirement, but I’ll leave that argument for another post).
Fewer companies are matching these days, and it may be a benefit on the way out, but as long as it’s there, take full advantage of it — it’s free money.
IRAs give you greater control over how your money is invested, since you’re not limited to the options available in your employer’s 401(k) program. Once you’ve maximized your employer’s match, switch over to an IRA.
The next step depends on whether you’re eligible for a Roth IRA. There are income limits on Roth contributions. For 2009, adjusted gross income (AGI) phaseouts begin at $105k for singles and $166k for married-filing-jointly, so check to see whether you’re eligible. The beauty of a Roth is that you never have to pay tax on it again. Having money in both pre-tax and post-tax accounts provides a hedge against tax increases. Someone’s going to have to pay the bill for all the billions going to bail out the banks, so it is likely that tax rates will increase in the future. You may come out ahead by paying the tax now.
Since the Roth is post-tax, putting $5k in a Roth is equivalent to putting $5k/(1-r), where r is your expected marginal tax rate in retirement. If your tax rate will be 30%, then $5k in a Roth is equivalent to $5k/0.7= $7100 in a 401(k).
In 2009, an individual can contribute a total of up to $5000 into a Roth or traditional IRA. That is, the total of the Roth and traditional IRA contributions can be $5,000 (not $5,000 each). The income must be earned (not, for example, from investments). If you are 50 years or older, the contribution limit is raised to $6,000.
Here’s an example. Let’s say you’re a young single guy earning $95k who wants to put $10k into a retirement account. His employer matches 50% of the first 6% of a 401(k) contribution. First: Take the match. Putting 6% of $95k, which is $5700, into the 401(k) maxes the match. Second: He is eligible to contribute to a Roth. After contributing $5700 to the 401(k), he has $4300 remaining of his original $10k budget. His federal tax rate is 28%, so let’s round up to 30% to include state tax. He could put $4300* 0.7 = $3010 into a Roth, leaving $4300 * 0.3 = $1290 to go to taxes.
So if our mythical man instead earned $150k/year, making him ineligible for a Roth, he could put 6% of $150k = $9000 into his 401(k) and $1000 into a traditional IRA.
If you want to go hog wild and max out your retirement contributions, you can do the following: Max out the 401(k) match, contribute the max to an IRA (Roth, preferably, or traditional), and then come back and max out the 401(k) contribution (presently $16,500, or $22,000 if age 50 or above).
In sum, the priority is:
- Max the 401(k) match, then
- Fund an IRA (Roth, preferably if eligible), then
- Fund the rest of the 401(k) limit.
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By day, Helen engineers new materials to make computer chips cheaper, better, and faster. When the son goes down (pun intended), she writes about personal finance at Affine Financial Services.
Great post, Helen. This makes a lot of sense to me.
Helen: With so many people job-hopping or being downsized these days, what are your thoughts on those tempted to cash out their 401(k) when the amount is relatively small?
Nina: The temptation can have two sources: 1) you may need the money if you’ve lost your job and 2) sheer laziness to open an IRA account. You can head off both problems by 1) establishing an emergency fund of 4-6 months expenses and 2) opening an IRA now, so that it’s ready to receive the rollover.
I’ve switched jobs a few times, too, and I just keep rolling the 401(k)’s into my IRA. Once the IRA’s established, it’s no more paperwork to roll it over than to cash it out.
It becomes less tempting after the 10% penalty + income tax due turns your $2000 into less than $1300. Far better to let it rest and grow into something more substantial through the power of compounded interest.
Of course that’s all well and good, but what if you’re really desperate? Say you’ve just been laid off and you have no savings. If I was in that spot, I’d probably choose to cash out rather than rack it up in credit card debt.
I did the same analysis and came to roughly the same conclusion, except that I think you can make a case for saving the excess in after-tax dollars (i.e just regular savings and investing, not any any tax-advantaged plan) once you’ve gotten your corporate match and maxed out your Roth.
My logic is mainly:
1) Tax rates are as low as they’ve been in several generations–you might well be better off just paying the taxes now, rather than paying them later at some unknown rate.
2) There’s always some risk that the government might change the rules in some way that disadvantages 401(k)s and IRAs. Not enough risk that I’d avoid them, but enough risk that I’d want at least some savings that’s not in such a plan.
More analysis in When NOT to put money in your 401(k).
Philip: I agree that it might be a good idea to leave the money in a conventional portfolio (i.e. not a retirement account) (of course after maxing out the employer match). Doing so gives you more flexibility in how to invest it.
For example, I’m a big fan of developing one or two rental properties as retirement income. While it is possible to fund rental properties with retirement funds, there is a significant amount of additional paperwork, there are additional fees, and you lose some of the tax advantages associated with income properties.
I agree that one should keep their options open by having a conventional investment account in addition to retirement accounts (both pre-tax and post-tax).
I guess one could say, “Moderation in all things.”
Thanks for your comment.