What is the ideal contribution to a 401k?
I contribute about 10% to my 401k. I want to know more about Roth IRAs. I have one with my company, but haven't contributed any percentage yet as I am not sure how much I should contribute. What exactly is a Roth IRA? Additionally, what is the ideal contribution to a 401k for someone making $48K a year?
Both Roth IRAs and Roth 401ks allow you to make after-tax contributions into these accounts, which allow the funds to grow tax-free—and distributions are tax-free in retirement. Roth IRAs and Roth 401ks each have their own set of rules. You should know them well before making any decision about changing your contribution strategy from your regular 401k deferrals to Roth 401k deferrals. It is important to note that retirement plans normally allow you to split your contributions between 401k and Roth 401k funds: It’s not an all-or-nothing decision.
Your current 401k deferrals are decreasing the amount of your federal and state income taxes. Roth 401k contributions, on the other hand, do not reduce your taxable income. They are considered an “after-tax” contribution. If you were to change your contribution strategy from 10% regular 401k, to 5% regular and 5% Roth 401k, you could be paying by my calculation $600 more in taxes at the Federal level, not including any additional state taxes. Please see the example below:
|Gross Income||$ 48,000.00|
|10% Contribution into Regular 401k||$ 4,800.00|
|Taxable Income||$ 43,200.00|
|Estimate Federal Income Tax||$ 6,571.25|
|Gross Income||$ 48,000.00|
|5% Contribution into Regular 401k||$ 2,400.00|
|Taxable Income||$ 45,600.00|
|Estimate Federal Income Tax||$ 7,171.25|
|5% Roth 401k Contribution||$ 2,400.00|
|(Roth 401k Contribution does not reduce taxable income)|
In both scenarios you are contributing 10% of your income. But in scenario 2, because you are not deferring 10% of your income into a regular 401k and reducing your taxable income, your tax bill increases from $6,571 to $7,171 ($600). My calculation does not take into consideration deductions you might have, but can give you a sense of how contributing to a Roth IRA affects your tax bill. You could consider contributing according to scenario 1 and then contribute the tax bill savings into a Roth IRA in addition to your 10% 401k contribution, thus increasing your total contribution.
Most financial planning studies suggest that the ideal contribution percentage to save for retirement is between 15-20% of gross income. These contributions could be made into a 401k plan, 401k match received from an employer, IRA, Roth IRA, and/or taxable accounts. This contribution goal can be applied to anybody saving for retirement. As your income grows, it is important to continue to save 15%-20% of your income so that you can invest the funds and grow your investments until you need to start taking distributions in retirement.
Great questions. First, let me address the question about "what is a Roth IRA?"
A Roth IRA is a retirement plan (a tax label as I tell clients) that means your contributions are made after-tax and distributions (as long as they have satisfied the Roth IRA requirements) are taken out tax-free. Roth IRAs also enjoy tax-free growth. You can read more about Roth IRAs here.
However, chances are your company has provided a Roth 401k option to you. This is similar to a Roth IRA, but can vary slightly. One difference would be you're not subjected to the same contribution limits. In a Roth IRA, you can only contribute $5,500 per year for someone under the age of 50 ($6,500 if you're 50 or older). However, a Roth 401k option would allow you contribute up the 401k max contribution limit, which is $18,000 per year as of 2016 ($24,000 if you're 50 or older). The Roth 401k also has no income limitations while the Roth IRA does.
Regarding your question about how much should you ideally contribute to your 401k....
The answer to this unfortunately involves many variables like:
-when do you plan to retire?
-what will your income requirement be during retirement?
-how are you choosing to invest your money now and what rate of return can your realistically expect from now until you retire?
-do you have any other sources of retirement income (like pensions, social security, etc.) and what is the total income generated from those accounts?
In general, I think 10% is a healthy contribution starting point. If your employer matches, that will also help you save faster. But, if your goals are to retire early or spend a lot in retirement, you may need to look at increasing what you're doing, especially if you don't have a company match. The answer to this question entirely depends on your retirement goals and other income sources. Social Security SHOULD be there for you, but based on your age, you may need to count on a reduced benefit if no legislative changes are made. In fact, you should expect a 20% reduction in benefits if no legislative changes are made by the year 2034.
Regarding your question about how much to save to a traditional 401k vs. a Roth option....
This depends on your tax situation. If you think you will be in a higher tax bracket in retirement, then you would want to contribute a higher percentage toward a Roth option today. This way, you'll pay taxes today (when you're in a lower tax bracket) and you won't have to pay taxes in the future. However, if you're like some that experience a lower tax bracket in retirement, then you'd be better off contributing to a traditional option. This way, you put off paying taxes until you hit the stage that you're in a lower tax bracket. It may be hard to predict what your tax situation will look like down the road, so it's not a bad idea to diversify your money into different tax buckets. In other words, do some to a traditional option and some to a Roth option.
I hope this information helps and good luck to you!
Joe Allaria, CFP®
A Roth IRA is a retirement account. It differs from a regular IRA in two important aspects. First the negative: you do not get a tax deduction for contributing to a Roth IRA. But there is a big positive: you do not have to pay taxes on money you take out during retirement. And, like a regular IRA, your money grows sheltered from taxes.
In general, the tax benefits of being able to get money out of a Roth IRA outweigh the advantages of the immediate tax deduction you get from making a contribution to a regular IRA. The younger you are and the lower your tax bracket, the bigger the benefit of a Roth IRA.
There is no “ideal” contribution to a 401k plan unless there is a company match. You should always take full advantage of a company match because it is essentially “free money” that the company gives you.
Ideal contribution rate for retirement depends on a few different factors, but a good sweet spot is 10-15%, more towards 15%, if you can afford to do so. The bare minimum is 10%.
Roth IRAs are retirement accounts where contributions are made on an after-tax basis. So let’s say you wanted to make a $5,000 contribution to a Roth IRA. Assuming you are in the 25% federal tax bracket, it would require $6,666 in order to do so. The extra $1,666 you would pay in taxes this year. The money in the Roth would grow tax-free and you will not have to pay any taxes on distributions in retirement.
The main reason why you would want to think about incorporating a Roth IRA into your overall portfolio is an expectation that you are going to be in a higher income tax bracket in the future. Let’s say right now you pay 25% in income tax and you expect to be in 28% in retirement. It is in your benefit to pay the tax now at 25% and put the money in a Roth, which will grow tax free, and when you need the money in retirement, you will forgo having to pay the 28% income tax, which is a net benefit to you.
It makes a lot of sense to utilize a Roth IRA if you are young since it is very likely that you will move into a higher tax bracket as your career grows and you make more money. Still, I would prioritize saving as much as you can versus the tax status. So if you receive an employer match in your 401(k), make sure you are contributing enough to earn the full match (at the very least). If you are younger, you probably want to make Roth contributions if you can. If not, keep saving as much as you can in the 401(k) to get the full match and then start to save in a Roth IRA.
Generally speaking, a 401k is an employer-based retirement plan (can also be used for self-employed persons) which employees can defer some of their income. An IRA is an “Individual” retirement account that anyone can have that is not related to their employment.
Both 401ks and IRA have “Roth” options. In a traditional 401k or IRA contributions typically go in pre-tax, earnings are tax-deferred while in the account, and all distributions are taxable when distributed. For Roth accounts, the contributions go in after-tax, grow tax-free, and the distributions are tax-free as long as you are over age 59 ½ and have had the account more than 5 years.
The only exception to this is when non-Roth after-tax contributions are made to IRAs, but this is beyond the scope of your question.
Anyone can defer income into a 401k or Roth 401k, however, the ability to contribute to a Roth IRA is limited when your (modified) Adjusted Gross Income reaches $184,000 and is eliminated when it reaches $194,000 (for a joint filer). Anyone can convert to an IRA regardless of income. At $48K of income you are well within the limits unless you have a high income earning spouse.
The decision to save pre-tax versus after-tax is largely a function of whether you think your tax bracket will be higher or lower than they are now when you take distributions. If you think your taxes will be lower then it makes sense to get the tax break now and pay less tax later via pre-tax 401k contributions. If however you think your tax rate will be higher (because of income sources and/or tax increases in general) then it makes sense to pay tax now to get tax-free distributions later via Roth IRA. One need not do one or the other, rather tax planning in this sense can involve “tax diversification” whereby you make contributions to both types of plans (if allowable) to have flexibility in your tax footprint in the future.
Another consideration is whether your employer has matching contributions in the 401k in which case you would want to contribute at least the amount to maximize the matching contribution.
As far as ideal contribution to a retirement plan in general is a function of what your goal is. Working with a qualified financial advisor can help you articulate what your retirement goals are and come up with a plan to get you there which would include advice on how much you should be contributing to different types of retirement and investment accounts.