Should I contribute to both my 401(k) and Roth IRA, or just focus on my IRA?
My employer offers a 50% 401(k) match, up to 3% of a minimum 6% pre-tax contribution from the employee (total 18% per month in savings, pre-tax, including the match). I can get within a couple hundred dollars of maximizing my Roth IRA contributions ($5,500/year). I contribute the minimum required to get the maximum match, and maximize contributions monthly to my Roth IRA. Given the fees for the 401(k), (I pay 0.04% for my Roth IRA) and its performance, which at best matches the S&P 500, does it make sense to still contribute to both? Or should I just focus on my IRA and use the extra cash in my paycheck to do other things (build savings, pay debt, invest elsewhere, etc.)?
I hear your dilemma! When you consider all financial matters (pre-tax saving, matching, bills to pay, tax to set aside…), what was originally a simple goal--saving for retirement--suddenly becomes very complicated. Consequently, you become paralyzed and hesitant to make any decisions.
Fear not! Here’re the simple rules of thumb: 1) If work provides a matching in a retirement account, please make the most of it. It is the free money for you, why not? 2) Next, max out your own IRA (Roth or Traditional). You’re counting on the principal of time value of the money in this instance. 3) Do an HSA (health savings account) if you have a high deductible health insurance. Not only you can deduct it, but you can also invest it. Don’t use it now as you still have earned income to meet all medical expenses. Use the HSA as your future retirement healthcare fund when you don’t have any earnings besides the social security, if it still exists. 4)Tackle debts. Yes, you save for yourself first before tackling debts unless you have a very unreasonable high interest rate.
If you still have confusion or questions over those rules, talk to a CFP®. All of my colleagues, myself included, can definitely help you build a budget and guide you to pay down debts and build the retirement fund. Best!
Great question, and congrats on doing a great job in saving for retirement. I would continue to at least contribute the 6% to your company's 401(k) to receive the match. The match is free money, and I can't think of a situation where that would not be the right thing to do. After that, you can max out your Roth IRA account. At a recent JP Morgan Conference we discussed this exact topic, so here is the typical priority that I suggest to clients:
- Emergency account (3-6 months of living expenses)
- 401(k) savings to maximize employer match
- Additional payments on higher interest loans (i.e. credit card debt/student loans with interest > 6%)
- Health Savings Account (if eligible)
- Additional 401(k) savings up to the maximum contribution
- Additional payments on lower interest loans (i.e. student loans with interest < 6%)
- IRA contributions (if eligible)
- Taxable accounts
Since you are concerned about high fees in your 401(k) then in step 5 replace that with maxing out your Roth IRA. I think the step most often skipped is #4 with the health savings account, but these really can be beneficial. Hope this was helpful, good luck to you!
This is a great question and you already have some excellent answers so I will simply try to fill in a few areas and reiterate some important points:
1) Certainly contrbute whatever is needed to maximize the match from your employer, this is "free" money that should not be overlooked.
2) Then max out your Roth IRA, this will allow you to build a pool of monies that will be accessible in retirement without any type of tax ramifications.
3) Depending on what tax bracket you are in today, it may make sense for you to contibute more to the 401(k). This is something I would consult with your tax advisor on to see if this is helpful or not. Should the tax benefits not be great, you may then consider investing outside of your 401(k) and Roth.
4) I would review the investment options available in your 401(k) to see if there is a better way to invest the funds that are currently there and being added to see if there are more cost effective options that will provide you with the cost, risk and potential reward you are looking to get.
5) Lastly, your questions straddles many areas-taxes, retirement planning, investment review, asset allocation- that it may make sense to consult with a fiduciary advisor that could help you navigate all of these areas to either confirm your current strategy or help you develop a better one that is tailored specifically for you.
Best of luck in your planning!
The easy answer is to take the match – its free money. But that is during the accumulation phase of your investing life. During the distribution phase, you will have to pay taxes on the 401k money, but not the Roth. So I looked at what the full cycle looked like. It is simple math on a spreadsheet.
I used a number of variables - how much was deposited each year, rate of return, and future tax rates, etc. Many times, the Roth, after tax, on the full cycle including distributions, outperformed the 401k. And many times it didn’t. It all depended on the variables.
If you are good with spreadsheets and can create one that will allow you to change the variables, I would suggest you spend some time doing real life projections. See what the long-term rate of return for the S&P 500 has been, (you may be surprised). Calculate your tax rate as a percentage of your income, not from the tax tables, they only show what your last dollars are taxed at. Determine what your future tax rate will be and estimate your expenses when retired so you can estimate how much you will need to withdraw from your Roth or 401k to live on. There are a number of other variables to consider as well, such as inflation, interest rates and so on.
If you cannot do this, I would suggest sitting down with a financial planner. We have planning software that takes these variables into account so that you can see what your options are. Nothing is ever in stone since variables will change over time, so financial plans and projections have to be updated as you go along.
You seem to have a grasp on what you are doing, but working it out on paper is always the best solution. Seeing how the numbers react to changes is the best way to determine the best course of action.
I hope this has been helpful and if you have any further questions, please feel free to contact me.
John Riley is a registered Research Analyst and has been the Chief Investment Strategist at Cornerstone Investment Services since 1999. (In the business since 1986.)
Disclosure: Third party posts do not reflect the views of Cantella & Co Inc. or Cornerstone Investment Services, LLC. Any links to third party sites are believed to be reliable but have not been independently reviewed by Cantella & Co. Inc or Cornerstone Investment Services, LLC. Securities offered through Cantella & Co., Inc., Member FINRA/SIPC. Advisory Services offered through Cornerstone Investment Services, LLC's RIA. Please refer to my website for states in which I am registered.
As most advisors will tell you, you should contribute at least as much to your 401K as to take advantage of your company match- that is free money and you are essentially getting an instantaneous 100% return on investment. Beyond that, I would recommend paying off any high interest debt (For example credit card debts that can have interest rates as high as 25% compounded daily!).
I would next recommend taking care of other things like an emergency cash fund with 6-12 months of expenses depending on your job stability and family situation. Any funds that maybe needed in the short term such as for a down payment for a house should be invested conservatively and in a taxable account so that it is available for use without restrictions.
Beyond that, the excess cash that you have should be invested for the long term. When investing people often fall into the trap of mental accounting ie treating different investment buckets differently- for example I have seen some people take more risk in their retirement account than in their taxable account. The optimal way to invest should be based on your risk return profile and should apply to all your invetsmen accounts. As such,the tax benefits of your 401K is a very powerful tool that I recommend you should take advantage of.
You mention that you are dis-satisfied with your 401K returns - within the investment choices that your 401K plan provides, you should be able to change your asset allocation. Further, depending on your salary level you may also be able to make a contribution to a traditional IRA which would have a similar tax benefit as a 401K but will have more in investment choices.