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Should I contribute towards a traditional 401(k), Roth 401(k), or Roth IRA?

I am a 22-year-old engineering graduate with zero student loans. My base salary before taxes is $65,000. I would like to contribute approximately 15 percent of my salary towards a retirement account. Would it be more beneficial to contribute 15 percent towards a traditional 401(k), a Roth 401(k), or split my contribution to 8 percent towards each? My company will match 100 percent of my contributions on the first 3 percent, and match 50 percent on the next 2 percnet of my base salary that I contribute. Additionally, if I am contributing to a 401(k), is it necessary to open a Roth IRA account?

Career / Compensation, 401(k), IRAs, Taxes, Retirement Plans, Starting Out
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July 2018

Congratulations on a great start to your career and retirement! Check your 401K plan fees, hopefully they are not excessive. Even with high relative fees, the match is worth doing up to 5%. Roth contributions are typically matched with regular 401K funds. You will pay on qualified withdrawals at 59.5 or later.

You don’t need a Roth IRA account. If you leave your employer and want to move the assets over, then you would create a Roth IRA and roll the Roth 401K into it. Roth IRA contributions income phase outs start at $120,000 for single tax filers with $5,500 max contributions. 401K’s have no income limits, but the total contribution limit is $18,500. (2018 information for those under 50.)

I would recommend the Roth in your scenario. Over time more detailed planning to optimize your retirement and tax efficiency could be highly valuable.

$12,350 Total Annual Savings. ($65,000 x 15% = $9,750 savings plus the match of $2,600= 4% x $65,000)

Only considering Federal taxes lets look at regular 401K contributions (tax deferred)

  • Lowers your current taxable income.
  • Given your $65,000 salary, your current 401K/IRA savings are lowering your income in the 22% tax bracket. (2018 tax brackets)

$9,750 only reduces your net income by $7,605.

  • $2,145 less in Federal taxes ($9,750 x 22% tax bracket)
  • $7,605 in lower total annual income ($9,750- $2,145 lower taxes)

Nice current tax benefit, but also consider future taxes.

Roth 401K(Roth IRA) contributions

  • Do not lower your current income, but you never pay taxes on qualified withdrawals.
  • Your $9,750 contribution lowers your net income by that amount.
  • The $2,600 matching is regular 401K assets.

To illustrate what may occur let’s take a hypothetical $12,350 a year total savings forward 40 years to your early 60’s at 5%. With these assumptions over $1.49 Million. (A vast oversimplification, but it leaves out raises, and all sorts of other positive and negative things that may occur.) With this much tax deferred assets there begins to be a danger of paying higher tax rates in your retirement than you are paying now.

Roth versus regular 401K/IRA assets fall into the taxes now versus taxes later pools. As you progress in your career and get raises, your tax bracket will tend to go up and therefor the value of regular 401K contributions goes up as well. Coordinating current versus future tax rates, your total assets and spending, can provide lifetime tax savings and efficiencies. In the future consider having an expert run the numbers with your specific goals and information. Saving is the most important thing, but tax efficiencies can improve your net lifetime income.

Hope this helps please feel to reach out to me with questions!

David Nash, CFA, CFP®

July 2018
July 2018