Should you save in a 401(k) or a Roth IRA?
You can — and in many cases, should — save in both a 401(k) and an IRA. But most people have a limited amount of money to put toward retirement each year, and both 401(k)s and IRAs have contribution limits. Which should you use first?
If you’re fortunate enough to have an employer-sponsored retirement plan like a 401(k), you may be wondering how to prioritize that against individual account options, including a traditional or Roth IRA. All three of these retirement plans have tax advantages you don’t want to pass up.
You can — and in many cases, should — save in both a 401(k) and an IRA. But most people have a limited amount of money to put toward retirement each year, and both 401(k)s and IRAs have contribution limits. That means the order in which you contribute to these accounts is important.
Which comes first? Here’s a general guide:
401(k) with matching dollars is priority one
Some companies offer 401(k) matching programs, which contribute to your account as you do, up to a limit. That makes your decision easy: You’d never want to walk away from free money.
The most common arrangement is currently dollar for dollar up to the first 6% contributed, which means if you earn $50,000 and contribute $3,000 to your 401(k), your employer will do the same.
Your employer’s contributions to your 401(k) do not count toward the account’s annual contribution limit, which is $18,000 in 2015.
If you don’t get a 401(k) match, start with an IRA
401(k)s are known for being fairly expensive investment options.
These plans have high administrative costs for things like accounting and legal services, and the employer often passes those on to the participants. The investments themselves are limited, with an average of around 20 choices offered per plan, so while plan providers have a responsibility to keep costs reasonable, it’s much harder for investors to shop around for the lowest expense ratio.
That means without an employer match, an IRA is generally a better first option. These accounts offer access to a virtually unlimited number and type of investments, so it’s fairly easy to minimize expense ratios with ETFs and index funds.
Traditional IRA vs. Roth IRA comes down to taxes
Both traditional and Roth IRAs allow contributions of $5,500 per year in 2015. They differ mainly in their tax treatment. A traditional IRA functions like a 401(k); you get a tax break when you contribute and pay the government its share when you make withdrawals.
A Roth IRA, on the other hand, is somewhat of a tax unicorn: Contributions aren’t tax-deductible, but distributions in retirement are completely tax-free, meaning participants in these plans never pay taxes on investment earnings. (Yes, you read that correctly.)
Most young people will want to choose a Roth IRA, because of that long time horizon for tax-free growth.
A Roth is also the best choice if you think your taxable income is lower now than it will be in retirement; many younger investors fall into this category, as their taxes are almost certainly destined to go up. (For more details about how to make this decision, check out our full post on the subject.)
Income limits may apply
The Roth comes with one big caveat: You can make the full contribution to a Roth only if your modified adjusted gross income is less than $183,000 (as a joint filer) or $116,000 (as a single filer). The contribution limit then starts to phase out. If you earn above this amount, you can contribute as much as the IRS allows to the Roth and the remainder to a traditional IRA.
The traditional IRA has no income limits on contributions, but things get hazy when you’re also a participant in a 401(k): You may be limited in the amount of your traditional IRA contribution that is deductible, depending on your income. That doesn’t mean you can’t contribute, but the tax deduction is a big perk of this account.
The bottom line
Even if you start right out of the gate at, say, 22, investing $5,500 a year in an IRA at a 7% return would leave you with around $1.4 million for retirement. That sounds like — and is — a lot of money, but it’s probably not enough.
A good retirement plan includes both a 401(k) and an IRA; the order in which you use them depends almost entirely on whether your employer offers matching dollars. And if you max out those tax-advantaged options, you can always open a taxable account.
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