For many of us, there are a lot of choices. These include a 401k, Roth 401k, Deductible IRA, Roth IRA, and a Non-deductible IRA. And that’s not even counting 403b accounts, SEP IRAs, Self-Directed IRAs, and, of course, taxable accounts.
That’s enough to make your head spin. Of course, for many of us, the best option is actually a combination of 401k, IRA, and taxable accounts. So, how do you know which combination will maximize your retirement savings?
I recently came across a post on the Bogleheads forum (which is an excellent investing forum, by the way) that addressed this very question. According to the good folks at Bogleheads (named after the founder of Vanguard, Jack Bogle), retirement investing should be placed in the following types of accounts, in the order listed:
1. 401k/403b, up to the company match
2. Max out Roth IRA
3. Max out 401k/403b
4. Taxable Investing
While your situation may be unique, I think the above priority ranking is, as a general rule, quite sound. Let’s look at the rationale behind this list.
Table of Contents:
1. 401k/403b Up to Company Match
When your employer matches some of your contributions, it’s critical to take full advantage of the match. Otherwise, you’re just turning away free money.
The value of the match makes this the ideal first place to stash your retirement savings. The average company seems to offer around 3% in matched contributions. There are, however, companies that offer as much as 50% or even 100%, up to a specified limit.
Be sure to check with your employer to see what percentage they match, what the maximum is, and if there are any other stipulations.
Let’s say you’re the type of person to front-load your contributions early in the year. If your employer matches up to a certain limit each month, you could still leave money on the table. You may need to switch up your contribution schedule and spread it throughout the year, in order to get every penny that you can off this free money.
Also, pay attention to whether your employer’s matched contributions require you to be vested or not. If you stay with the company for your entire career, this isn’t an issue. However, if you decide to leave your job at some point, you may or may not be able to take your entire retirement account with you–which could be a very costly mistake.
2. Roth IRA
Once you’re saving enough in a 401k to get the company match, additional retirement savings should go to a Roth IRA, according to the Bogleheads. While I think arguments to the contrary could be made here, I like this approach for two reasons.
First, most people generally assume that taxes will go up in the future. So, unless you are in the top brackets today (tax brackets) or have reason to believe that you will be in a lower bracket at retirement, this is sound advice.
Many recommend paying the taxes on the income now, which is exactly what you do when you contribute to a Roth IRA with after-tax earnings. Then, you can sit back and enjoy both tax-free growth and tax-free retirement distributions later.
With retirement savings in both a 401k and Roth IRA, you have some investments that are tax-deferred and some that grow tax-free. This is a nice way to hedge your bets when it comes to future taxes.
Second, with any IRA, you can choose where to open the account. Many 401k plans charge extremely high fees and have limited investment options. For those who like to keep investing simple, Betterment is an excellent option for an IRA (you can read my review here).
If you like to trade, I think Scottrade is a great choice because of low fees and physical branches just about everywhere, but there are many brokers that offer IRA accounts.
Keep in mind that your income may disqualify you from opening a Roth IRA. You can check out the Roth IRA limits here.
3. Max Out 401k/403b
Once you’ve maxed out your Roth IRA, additional savings can go toward topping off your 401k. Even though you won’t be benefiting from additional employer contributions, the tax benefits still make this an excellent retirement vehicle to focus your efforts on.
Keep in mind the limits on contributions, which can change from year to year. For 2017, the contribution limit is still set at $18,000 (we don’t have 2018 numbers just yet, but will update our 401k contribution limits page when they are available). The catch-up contribution limit for those aged 50 and over remains unchanged at $6,000, bringing the total allowed contribution to $24,000 for them.
4. Taxable Accounts
Unless you qualify for a SEP IRA, the next and last stop is to put your savings in a taxable account.
Roth IRA vs Traditional IRA
You may be wondering what the difference is between a Roth and a traditional IRA, and why we suggest contributing to the former first.
A traditional IRA and a Roth both have the same contribution limits ($5,500, as mentioned above, unless you’re over 50). You also have more than a year to contribute to your IRA — instead of December 31 being the last day you can put money in your IRA for the 2017 year, you can actually continue contributing all the way until April 15 of the following year.
However, that’s pretty much where the similarities stop.
A Roth IRA, as we talked about, is built with after-tax earnings. Because of this, your money will grow tax-free. When you take contributions in retirement, that money can be withdrawn tax-free, as well. (This is why a Roth is a smart choice if you foresee being in a higher tax bracket in the future than you are in now.)
The Roth also has those income limits we talked about, in order to qualify. However, you are not required to begin taking distributions from your Roth at a specific age, and you can also withdraw your contributions at any time before retirement without penalty.
So, what about a traditional IRA? Well, with this account, you get the benefits now.
All of your contributions to a traditional IRA will be made with pre-tax dollars. Contributions are tax-deductible and earnings grow tax-deferred. However, when you go to withdraw in your later years, you will be taxed at then-current income tax rates.
If you want to withdraw funds from your traditional IRA before reaching 59 ½ years of age, you’ll likely be subject to a 10% early distribution penalty, in addition to taxes. Once you hit age 70 ½, you have no choice but to begin taking money from the account. These are called Required Minimum Distributions (or RMDs).
401k vs IRA
So then, what’s the big difference between a 401k and an IRA?
First of all, there’s the issue of contribution limits. There’s a big discrepancy between what you can put away in an IRA ($5,500 / $6,500) and what you can put into a 401k ($18,000 / $24,000).
By definition, 401k plans are established and sponsored through your employer directly. The contributions made are deferred directly from your paycheck, without you ever touching the money yourself. Roth IRAs, however, are between an individual and an investment firm. This means that your employer will not have a role in your Roth IRA and has no opportunity to match your contributions.
An IRA has many more investment options than a 401k. In fact, your options are almost endless with an IRA, whereas the average 401k has about 20 fund options . Also, keep in mind that 401k management fees are often much higher than those of IRAs.
When you leave your employer’s company, you cannot continue to contribute to their 401k. You can choose to leave it alone or roll it over into an IRA. An IRA, on the other hand, is yours to contribute to, regardless of who employs you.
There are some similarities, though. For instance, you can make extended contributions to both your 401k and your IRA, up to the tax-filing deadline the following spring. This means that for 2017, you can put money in these retirement accounts all the way up to April 15, 2018, and it will still count toward your 2017 contribution limit.
Finding Your Own Perfect Plan
As mentioned above, every situation is different. The above priority list, while a great plan for many investors, may not be ideal for everybody. Take into account your own employer’s offerings, your ability to contribute to retirement savings, and whether or not your income qualifies you for things like a Roth IRA.
You may need to tweak the list above to match your own situation. At the end of the day, though, I think it’s a very sound way to approach retirement investing.
Have you approached retirement savings in a similar order? How has it worked for you and would you recommend the same to others? Sound off below.