Should my extra income go towards my 401(k), Roth IRA, or non-retirement account?
I'm a 26-year-old professional with a 401(k), a Roth IRA, and a non- retirement account. I contribute enough to my 401(k) to get my employer's match, and I try to max out my Roth IRA every year. But of those three accounts, where should my extra income be going? I'm not sure what's best to focus on at this point in my career. Additionally, I work for a non-profit, so I only have an extra $5,000-$10,000 to play with.
I love your commitment to saving at a young age, it's definitely going to pay off!
With an extra $5,000 - $10,000 in savings capacity at your age, I would first try and save in a Roth account. Since you are already maxing your Roth IRA, you could contribute to a spouses Roth IRA (if you're married) or look into your employers 401(k) plan to see if they offer a Roth 401(k) option. If they don't, make the recommendation, it's not going to cost them time or money and is easy to add on to a retirement plan. In the case you can't contribute to a spouses Roth IRA or your employers Roth 401(k), put additional money into your Traditional 401(k). If you get to the point where you're maxing that out, then put the remainder in your taxable brokerage account. At your age, you'd most likely be investing in high growth funds or stocks that shouldn't generate much income, so your tax bill won't be high unless you build up a large capital gain and sell.
All 401(k) contributions you make act as dollar for dollar reductions to your taxable income, thereby lowering your tax rate. Any extra after you reach the contribution limit should go to Roth contributions for the tax free advantages.
That really may come down to a value judgment. One of the biggest mistakes I see investors make is that they are so worried about the tax deduction, they put everything into tax deferred vehicles. Then they have nothing on the outside in a taxable account. So when they want to make an alternative investment, real estate, etc., they a paralyzed due to the inability to access funds in their retirement accounts.
I usually tell my clients they should have, at a minimum, around 30% on the outside and 70% on the inside, but this is a broad rule of thumb. Without knowing your particulars, it is difficult to say. You do want to put enough in your 401(k) to get the full max because this is "free money" with a 50% or 100% return depending on the match. And nobody is that good.
I guess what I am trying to say is that if you don't have much on the outside, I would begin to build that up. If you already have adequate savings on the outside, then a combination of your 401(k) and Roth is in order. Hope this stimulates your thinking.
Best of luck, Dan Stewart CFA®
I commend you for being proactive with your finances and starting to invest early. Assuming you are paying down on any existing debt and have set aside sufficient emergency fund assets, I believe your current strategy is fantastic. The 401(k) is a must in order to take advantage of your employer match and as an added bonus, you received a welcome tax deduction. As a fellow millennial, I firmly believe that maximizing the Roth IRA is one of the best financial decisions you can make. Compound interest over long periods of time in a Roth IRA will allow you the opportunity to create a large tax free nest egg for later in life. Investing in an after tax non-retirement account is a great idea if you are maxing out your Roth. This will allow you to create wealth outside of your retirement assets and ultimately allow you to be more flexible.
Great job so far with your savings! If only everyone started out like you have. At 26 years old, if you are saving 10% of your own money (not counting employer match) in retirement accounts, I'd say that's good enough for now. Think about your medium term financial goals (buy a house, car, puppy, vacation, engagement ring, start a business) and start saving and investing towards those in a taxable account. That way, you have investments you can access at any time, not just retirement.