Reader Question; Roth or 401 K, Which to Max Out First?

By on Dec 28, 2011 in Advanced Investing, Investing, Reader Question, Retirement, Saving | 11 comments

 Here’s a thoughtful question from Buck Inspire from the article, Contribute to a Roth IRA Today

Buck Inspire: Thanks for the reminder to get more into my Roth!  I also fund my rollovers and Individul  401k.  Which do you think should be maxed out first?  Roth or 401k’s?

This is an excellent question, which to max out first, a 401K or a Roth IRA?

The easy answer, max out both the 401K and the Roth IRA!

What if I Can’t Max out Both My Roth IRA and 401K?

Obviously, if you had unlimited funds, you wouldn’t be reading this blog! In the real world we all need to make financial choices. Where to allocate retirement funds is a common question for investors.

The simple answer is, if your company matches your investment in a 401K, make sure to contribute enough to get the employer match.

After you receive the FREE employer money, then the decision whether to go with the Roth or 401K depends on your answers to these questions:

  • What is your tax bracket now?
  • Do you think you will be in a higher or lower tax bracket upon retirement?
  • Do you like the investments offered in your workplace 401K?

Predicting the Future

I don’t know about you, but my fortune telling skill is limited. Although I believe that tax rates will be higher in the future, I’m not sure if my personal tax rate will be higher. After all, in retirement, my salary income will be gone and I’ll be

How Rich Will I Be?

living on pension, social security, and our invested assets! Again, my soothsaying tells me that this income will be lower than our current income.

How to Choose?

I can’t give Buck a definitive answer without looking at lots of personal information. I can give Buck some analytical ideas to help him decide.

If you really need a tax break now because your income and tax brackets are high, and you think that they will be lower in the future, then the 401K may be the one to max out first. As long as you are happy with the investment choices available in the 401K.

For the newbies out there, a 401K investment removes your contributions from federal taxation now (because you contribute pre tax dollars). The monies continue to grow tax free. But, when you take the funds out at retirement, you pay tax on them plus tax on any earnings as well.

With a Roth, you pay tax on all of your income, and then contribute “after tax” funds to the Roth. These funds grow tax free just like with the 401K. Upon retirement, or at anytime after age 59 1/2 you can withdraw these funds without paying tax on them! It’s a sweet deal.

If your tax bracket is not in the stratosphere now, the Roth IRA has some important advantages.

You choose your preferred investments.

All withdrawals are tax free.

There is never a requirement to withdraw the funds from a Roth IRA.

As with any investing decision, certain assumptions are made. In reality, those assumptions may turn out to be correct or incorrect. So, make the best decision now, with the information you have.

Have any of you dealt with this decision? Did you choose to max out your 401K or Roth IRA?

Caveat; As with all investment decisions, this is not a recommendation to buy or sell any investment product. Before making any investment decisions, please consult your own investment advisor.

image credit; Photo Knight

    11 Comments

  1. Where I work I get to have it both ways. They started a relatively new account option called the Roth 401K which is a 401K that is setup like a Roth IRA. The matching funds go into a normal tax deductible IRA.

    The real win here is that the contribution limits are the 401K limits (16.5K) not the Roth limits (5K). Check with your employer, they may offer it.

    sfi

    Six Figure Investor

    December 28, 2011

  2. I love that the Roth 401K is becoming more prevalent.

    I think you bring out some good points about how the decision (choosing between the Roth IRA and the 401K) has important tax implications that should not be ignored.

    Roshawn @ Watson Inc

    December 28, 2011

  3. If I have to make a choice, I would fund the IRA or 401K first. It is unlikely that I will be in a higher tax bracket in retirement. It does not mean I am not hedging my bet by funding my Roth IRA too. If I have to chose I would fund the IRA first. My theory is that I may be able to reduce my taxes later if I have higher taxable income. For example, I can withdraw from IRA at a lower rate and extend the life to 30 years versus 25 years.

    krantcents

    December 28, 2011

  4. Good advice Barb! That’s exactly what I do. Max out ROTH, match company match on my 401K.

    Personally I don’t like 401Ks. Limited choice, high fees. With ROTH I have much more control and I can access my contribution anytime I please.

    Moneycone

    December 28, 2011

  5. @6 Figure, You are a winner. The Roth 401 K is relatively new and a great alternative!!
    @Roshawn, The tough part is you don’t know if you made the right decision or not until you reach retirement age! Kind of like life, there’s a lot of uncertainty!
    @Moneycone-Sounds like you are getting the best of both worlds.
    @Robert-I cringe when I hear of people who give up the company match by not investing in their 401K. Ouch!

    Barb

    December 28, 2011

  6. As you said, it’s an easy choice to pick the 401k if there’s an employer match. In fact, funding a 401k in that situation is better than almost anything you can do with your money (it’s free money!)

    For those of us that don’t have access to an employer match, it’s not so clear. I’m simply sticking with funding the Roth for now.

    Jeffrey

    December 28, 2011

  7. Thanks for taking the time to answer my question! I have a better idea on how to manage my retirement funds. I hope this post helps others with the same question. Thanks again Barb!

    Buck Inspire

    December 29, 2011

  8. @Jeff-Personally, if it’s an either/or, I’d go with the ROTH as well. Why not work towards funding both?
    @Buck-My pleasure!!

    Barb

    December 29, 2011

  9. Had a friend ask me a similar question yesterday. 401k or Roth 401k? Passed along fairly similar thoughts, as long as she gets the employer match at a minimum. Great Advice!

    JP @ Novel Investor

    December 29, 2011

  10. @JP- I am extrememly gratified when good personal finance gets passed around!!

    Barb

    December 30, 2011

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