Most of us have 401(k) or 403(b) retirement plans at work, right? A question I’m often asked is whether it’s better to contribute to a Roth IRA or a 401(k). The easy answer is both, if your income allows. Let’s discuss the differences and similarities between the two types of retirement accounts and how to make your contributions work to your advantage. Oh, and remember, the goal is to give Uncle Sam the least amount of money as legally possible.
In 2010, individuals under 50 are allowed a maximum annual contribution of $5,000 into a Roth IRA and $16,500 into a 401(k). You can’t deduct Roth IRA contributions on your tax return, so contributions are after-tax. 401(k) contributions come directly from your paycheck before taxes have been paid, so contributions are pre-tax. Both accounts grow tax-free.This is nice! A word of caution: Don’t withdraw money from either of these accounts before age 59 ½ or you will have to pay income tax, plus a 10-percent penalty.
Now, let’s skip ahead to age 59 ½....
DON’T QUIT ON ME NOW, KEEP READING!
Here’s where the big difference comes in. At age 59 ½, you can withdraw your Roth IRA assets tax-free, while your 401(k) distributions are taxed at the ordinary income rate. Since most of us are in a lower tax bracket today than we will be 25 to 30 years from now, it makes more sense to pay taxes on our contributions now rather than paying a higher tax rate later in life. Remember, our goal is to give Uncle Sam the least amount of money as possible.
Maximizing Your Contributions
Here’s a strategy that will help you out-smart Uncle Sam! First, calculate the amount of money you have to work with. For instance, if you make $70,000 per year and you want to save 15 percent, you will have $10,500 to work with. Then, contribute enough money to your 401(k) to take advantage of any matching funds from your employer. If your employer matches your 401(k) contribution dollar-for-dollar, up to 5 percent of your salary, you would put $3,500 into your 401(k), no matter how poor your investment options are! Next, make your maximum Roth IRA contribution, which is $5,000. You have now saved $8,500. Finally, contribute the remainder of the 15 percent of your income, or $2,000, into your 401(k) account. (If your 401(k) investment options are not the greatest, place this portion into your taxable brokerage account instead.) You have now done your job and have contributed $5,500 into your 401(k) and $5,000 into your Roth IRA. See how easy that was!If you are unable to contribute into a Roth IRA because you make too much money, don’t worry. There are other strategies that allow your Roth IRA to be fully funded each year. Furthermore, some 401(k) plans have the option of allowing Roth 401(k) contributions, so ask your plan provider if the Roth option is available, and contact me to discuss it further.
Thanks for listening everyone, please e-mail or give me a call to address your unique situation and to help you choose appropriate investment options.