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?
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®
Great question. Being that you're 22 I would highly consider putting funds towards a Roth. Even if you do a 100% Roth the company's matching contributions will be placed in a traditional 401k account (since their contribution is pre-tax).
I know many clients like doing a portion in both the Traditional and Roth 401k (50/50)...but I would recommend no less than 50% in a Roth.
As for the second part of your question you can contribute to a Roth IRA outside as long as you don't hit the qualified contribution amount of $18,500 (for 2018) for all accounts.
Great job at contributing and saving for your retirement.
Great question, and great job on getting started on your retirement account right away. If you can start putting 15% away this early it will really benefit you in the long run. If you're single and making $65,000 then you're in the 22% tax bracket which is in the middle so not too high. I would suggest contributing to the Roth 401(k) now. As you work your way up the ladder you'll want the tax benefit of the traditional 401(k). Everything the company puts in will be pre-tax so even if you do the Roth you'll be growing a tax free and pre-tax bucket. If your firm is of a decent size (say over 50 employees) then your 401(k) shouldn't be very expensive and I'd say contribute everything to the 401(k) until you eventually max out your contributions at $18,500 a year. The company's match doesn't count toward that number. If, however, the 401(k) has fund expenses around 1% or more then there may be high fees in here and I'd consider opening a Roth IRA to reduce the fee drag. At 22 years old risk is your friend so feel free to invest in index ETFs to get market returns with minimal fees.
Good luck to you, you're making great decisions that your future self will appreciate!
Matt Ahrens, CIMA®