Should I contribute to a 401k or Roth IRA?

Should I contribute to a 401k or Roth IRA?

Should I contribute to a 401k or Roth IRA?

If you have just started your first job or a new job that offers a 401k, now is the time to kick-start your savings.

It’s actually best to save in both your 401k and a Roth IRA, and here are the reasons why.

The 401k

Regular 401k contributions are before tax, both federal and state.  This means that you will save on taxes right now.  When you withdraw the money in retirement you will owe taxes on the entire amount, including all growth.

I like to think about it this way: you get to save taxes on the “seed” but pay taxes later on the “crop”.  This makes a lot of sense since most people are in a higher tax bracket during their working years and a lower tax bracket during retirement.

If your employer offers a match, make sure to save up to that amount.  It’s common for many employers to offer a 100% match on the first 3% of salary contributed.  This is free money so take advantage of it!

Even if your 401k has high-cost funds and high fees, it is still worth contributing enough to get the full company match.  The match will more than make up for these fees.

The Roth IRA

The Roth IRA can be opened at any investment company, and you can invest in just about anything.  You are not limited to certain funds like in your 401k plan.  It’s also not linked to your employer.

With a Roth IRA your contributions are after tax, but your future distributions are tax-free.  I like to think of this as paying taxes on the “seed” and getting the entire “crop” tax-free!

If you are in your 20s and 30s, it makes a great deal of sense to put some of your retirement savings in a Roth IRA.  When you are younger you are usually in a lower tax bracket since you have not yet reached your peak earning years.  You also have the next 30- 40 years of investment compounding ahead of you to work its magic.

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Tax Diversification and Other Advantages

You may have heard of investment diversification, but the Roth IRA will also give you the benefit of tax diversification.  Since the withdrawals are not taxed, it can help you balance your income during retirement.  If you need more income in a single year, you could take it from your Roth IRA and stay in a lower tax bracket.

The Roth IRA can also be used as an extra emergency fund up to the amount that you put in.  In certain cases, withdrawals are also penalty free for education expenses or the purchase of a home.

Kick-Start Your Saving in this order:

  • 401k up to the Company Matching %
  • Roth IRA up to the annual max ($5,500 in 2017)
  • If you have additional money available, either continue to max out the 401k (up to $18k in 2017), or open a taxable brokerage account and invest in low-cost ETFs or index funds.

 

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Charles W. Malsbury, CFP®
malsbury@thinkplansave.com
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