Both 401(k)s and Roth accounts are retirement savings vehicles, but the key distinction lies in their tax treatment: 401(k)s offer pre-tax contributions with taxable withdrawals, while Roth accounts feature after-tax contributions with tax-free withdrawals in retirement.
How much can you contribute?
Both 401(k)s and IRAs, including Roth IRAs, offer valuable tax benefits, allowing contributions to both types of accounts. In 2023, the 401(k) contribution limit is $22,500 ($30,000 for those 50 or older), while the IRA limit is $6,500 ($7,500 for those 50 or older). In 2024, the 401(k) limit increases to $23,000 ($30,500 for those 50 or older), and the IRA limit rises to $7,000 ($8,000 for those 50 or older).
Which one should you contribute to first?
Contributing to both a 401(k) and IRA is beneficial, but how should you allocate your savings between the two?
If your employer offers a 401(k) match:
It’s advisable to contribute enough to maximize this benefit. Check your employee benefits handbook for details. Taking advantage of your employer’s matching program is a significant perk of a 401(k), wherein your employer contributes to your account based on your savings, usually up to a specified limit, often around 6% of your earnings. Despite any limitations in investment choices or higher fees, prioritizing contributions to receive the full company match is crucial, as it ensures a guaranteed return on those funds. Additionally, it’s important to note that employer contributions do not count toward the annual 401(k) contribution limit.
Next, evaluate contributing the maximum amount to an IRA. Your choice between a Roth or traditional IRA determines whether you receive your tax benefit upfront or when you begin withdrawing funds in retirement.
Traditional IRA: A traditional IRA (Individual Retirement Account) is beneficial for individuals looking to receive an immediate tax benefit. Contributions to a traditional IRA may be tax-deductible, meaning that the amount contributed reduces taxable income for the year in which the contribution is made. This upfront tax deduction can be advantageous for those who want to lower their current taxable income.
Roth IRA: A Roth IRA is a tax-advantaged retirement savings account known for its primary benefit: tax-free withdrawals in retirement. It is suitable for individuals who anticipate a higher tax bracket in retirement, offering tax diversification and flexibility. With no required minimum distributions and the ability to withdraw contributions at any time without penalties, a Roth IRA provides a versatile and tax-efficient option for long-term savings.
If your employer does not offer a 401(k) match:
Contribute to your retirement account first. When employers don’t match retirement contributions, many individuals opt for an IRA and contribute up to the maximum allowable limit as a wise first step in their retirement savings strategy. Choosing an IRA offers unparalleled flexibility in investment options, contrasting with some employer-sponsored plans. This flexibility empowers individuals with greater control over their portfolios, allowing strategic selection from a wide range of investments to align with their risk tolerance, financial goals, and investment preferences.
After maximizing IRA benefits, consider contributing to your 401(k), capitalizing on the tax deferral advantage of employer-sponsored plans. However, be mindful of income thresholds, as eligibility for traditional IRA deductions may be affected if you or your spouse contribute to a workplace plan. In such cases, a Roth IRA may still be an option, and making nondeductible contributions allows for tax-deferred investment growth. Additionally, the possibility of a backdoor Roth IRA conversion exists, offering flexibility in optimizing your retirement savings strategy.
Roth IRAs and 401(k)s are key retirement savings tools, each offering distinct advantages. Roth IRAs provide tax-free withdrawals in retirement, while 401(k)s offer immediate tax benefits and employer matches. It’s often suggested to prioritize maxing out your 401(k) first due to higher contribution limits, employer contributions, and the potential for upfront tax advantages. However, a comprehensive retirement strategy might involve utilizing both accounts to optimize tax benefits and overall savings.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Please consult your financial advisor prior to investing.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. Contributions to a traditional IRA may be tax-deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 may result in a 10% IRS penalty tax in addition to current income tax.