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On Wednesdays I answer Reader Questions. If you have a money question, write in. You may be considered for a Wednesday column.
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
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.
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image credit; Photo Knight