Should I contribute more to my 401(k) and Roth IRA to reach my deferral limit in a given year?
I contribute enough of my income to my 401(k) plan to get the maximum match from my employer. I also have a Roth IRA that I occasionally contribute to. Contributing to both of these isn't enough to get me to the deferral limit for any given year. I have more than six months of emergency funds. Should I contribute more to my 401(k) plan or to my Roth IRA? Should I open up a brokerage account as well so that I can reach my deferral limit?
This seems to end up as the opinion of the one answering this kind of question. If you ask tax preparers, they want to reduce current income taxes and defer growth. Financial advisors fall in the middle depending on their background and experiences. I applaud you for having six months of emergency funds and would ask you to consider the other possible events that could cause you to need money prior to retirement. Also, do you believe tax rates will go down by the time you retire?
My advice is normally this: 1) get the maximum match from your employer through your 401k. 2) If you are able to contribute to a Roth then do the maximum contribution that you are allowed. 3) Look for other ways to grow your non-emergency money in the most tax efficient manner, i.e. growth stocks, zero coupon municipal bonds (if you can find some good ones), and whole/universal life insurance. You want to make sure that you can access money prior to retirement without IRS penalties and taxes. You also want to make sure that you do the best you can to reduce or eliminate taxes. Tax deferral simply puts off what you know about taxes today for the unknown taxes of tomorrow. It also locks you out of your money until you are 59.5 years old.
I would suggest that you gross up your 401(k) contribution so that you can maximize this tax-favored savings plan. Many employees mistakenly stop contribution at a level that maximizes their employer's match but doesn't reach the plan maximum. The rules allow you to contribute up to $18,000 and an additional $6,000 catch up contribution, if you are over 50.
Even if you max out your 401(k) plan, you may still be able to contribute to a ROTH IRA, if your income is less than $196,000 and you file a joint return ($118,000, if you file singly). So, you may be able to do both.
To answer this question you'd need a glass ball to see into the future. We're unsure of what taxes will look like 10, 20, 30 years from now. However, one thing is for sure, having options when you retire gives you the flexibility to control your taxes. For instance, choosing whether to withdrawal from a pre-tax 401(k) or IRA and paying income taxes if you're in a low tax bracket, or being able to pay no taxes on withdrawals from a Roth if you're in a high tax bracket.
Considering you're contributing up to your employers match already, you may consider maxing out your Roth IRA with additional funds. A benefit of IRA's is you aren't restricted to investment options as you are in a 401(k). You can choose from the entire universe of investments available, which you can use to your advantage. Holding tax in-efficient securities like REITs, or MLP's in tax-deferred retirement accounts, helps them grow more quickly compared to being held in a taxable brokerage account.
Any additional funds after maxing out a Roth could be either used to max out your 401(k) or invested in a brokerage account as you suggest. You'd consider going the brokerage route if you potentially are investing for something in the nearer future than retirement. For example, starting a business down the road, or buying a home. The 401(k) would penalize you with distributions before age 59.5, so designating money for those purposes in a taxable account would avoid the 10% penalty and allow for better liquidity.
If you have good investment options in your 401k than contribute up to the maiximum there and then contribute to the Roth IRA with remaining funds. To know if you have good investment options look to see if you have access to index vehicles that have low investment expenses. This can be found on the 401k website where you make investment options. If those type of investment do not exist in your plan than continue to contribute to get the company match but than use funds to contribute to the Roth IRA.
I hope this helps.
Without knowing all of the details of your overall assets, age, and plans, I cannot give you sound advice. That said, normally the younger you are and the lower your tax rate, the more attractive a Roth becomes. But since you have 6 months of emergency funds, you obviously save on the outside fairly adequately. I would have those "emergency" funds invested somehow other than savings accounts because in this low interest rate environment you will not even keep up with inflation and have guaranteed losses on purchasing power. Over time, this can decrease your overall wealth potential.
If you are at a higher tax rate, then you should consider putting more into the 401k, especially if you are older. This way you would be able to put more money in due to the tax savings. If you are at a lower tax rate and are younger, then I would max the Roth out first & then add any additional amounts towards your 401k. Again, this is a generalization without knowing your details.
Hope this helps and Happy New Year, Dan Stewart CFA®