Editors' pick: Originally published Oct. 12.
It's a perennial question: Should I max out my 401(k) or my Roth IRA first? To make the choice, you need to think through where you should be saving money along with the advantages and disadvantages of each decision.
Most advisors will start in with some rhetoric about where you believe taxes will be in the future. While you should include taxes in your decision-making process, don't allow taxes to carry more weight than they should, because ultimately there is no way around paying them.
401(k)s are designed to give the tax advantage up front while Roth IRA's are designed to get the tax advantage on the back end. Both have their place as savings vehicle. One should also not discount a traditional IRA with tax advantages up front, because they give you more investment options, less in fees typically and aren't tied to an employer.
Let's start with the 401(k). If you are not getting a match on your money, then stay away from a 401(k) all together. They typically have few investment options, higher fees, and limitations by tying your contributions to your employment. Plus, to keep what your employer matches, most have a vesting schedule for how long you must stay employed. Know this number, because if you aren't staying 5 years and they require 5 years, the match is a lot lower and may not be worth it. A 401(k) only makes sense for the higher ability to save tax-deferred now and the employer match.
"If you work for an employer who provides a matching provision inside the 401(k), the first spot to save money is in the 401(k)," says Craig Wear, Founder of Q3 Advisors and Game Plan Advisors. "However, that doesn't necessarily mean that the employee should max out the total contribution allowed. We like to see employees max out the match and then move to investment buckets that provide them more control and less expensive investment options."
The most common match I see is a 50% match up to 6% of your pay. This means if you make $100,000 a year, to maximize the match, you need to save $6,000, and they will give you $3,000 as a match. This is free money. This is smart money. This is good return on your investment money.
"I would definitely consider the 401(k) match as an advantage over the IRA; however, it should be seen as a stepping-stone to accomplish one's particular goals and objectives," says Eric Brown, president of Integrity Financial Services, Inc. "The 'free money' from the company may have some type of vesting schedule as an incentive to keep the employee from leaving the company. However, a 25% or 50% match on your dollar is a fantastic return, which can substantially boost your savings for retirement."
On the Roth advantages Brown added, "Once one leaves the company, or attains the age requirement for rolling over 401k money into an IRA, it would be prudent to investigate some of the various investment opportunities that are available within a 'self-directed' IRA. I recommend self-directed IRAs for the flexibility in investment choices, in addition to the ability to control 'known' fees."
I do not recommend saving money in a 401(k) beyond the match. Once you've maxed the match, look for savings options outside of your employer. It could be cash, real estate, a brokerage account or an IRA or Roth IRA.
One advantage of an IRA that most don't consider is if you like the tax savings up front, you can place money in your 401(k) and IRA in the same year for a great tax deferral. Another advantage with both an IRA and a Roth is the ability to use self-directed IRA accounts that open up a much larger pool of investment and lending options.
Wear continues, "A self-directed IRA opened through a national brokerage firm or investment advisor has almost limitless alternatives from which to select investments to grow and protect your savings."
A Roth IRA is for money you pay taxes on up front but then never pay taxes again on the money or the earnings. Roth's are great for hedging against higher tax rates in the future, passing on to family and for doing your own investing. Roth's are even more lenient on penalties if you needed to access your money in an emergency.
Some equate using a Roth IRA as paying tax on the seeds today and not the harvest tomorrow. Roth IRAs are a great tax advantaged tool to be familiar with. For those that earn too much, properly built cash value life insurance fills the tax advantage void.
So if taxes are a part of your decision making process, you need to decide how much of your money you want a tax benefit with now and how much you want a tax benefit with down the road. In recent years some employers have started offering Roth 401(k)s that are similar to a Roth IRA but with a higher contribution maximum.