I recently wrote about paying yourself first, and one astute commenter had a great question about the value of maxing your Roth IRA first or your company’s 401(k) plan first.
Thomas asked, “I agree with the at least maximize your employer match but have been confused as to why people don’t max out 401k first before adding to ROTH?”
The Advantages of a 401(k)
A 401(k) is a tax advantaged account used for retirement. Contributions to a 401(k) account are usually matched by an employer. If you have any 401(k) matching available, take 100% of it. If you don’t, you are leaving free money on the table.
401(k) accounts are funded before tax. That means you put money into your 401(k) without paying any taxes on it. The taxes are deferred until you retire, presumably at a lower tax rate as you will have less income.
By deferring the taxes, you are saving money due to inflation over your career. When you begin to make withdrawals, you pay taxes on your 401(k) as income. If you are very near retirement, this is the best option for retirement investing.
The Advantages of a Roth
A Roth IRA account is another tax advantaged account. Most of the time, employers do not support a Roth account, so you have to set one up on your own. I have my Roth at Charles Schwab and put the maximum allowed amount ($5,000 per year in 2012 and $5,500 per year in 2013).
In a Roth IRA, you pay taxes on the income and pay no taxes when you withdraw your funds in retirement. By paying taxes up front, you get to keep the capital gains of your investments tax free.
This is the best option for someone with a longer horizon before retirement.
Which is Better for You?
Each of us has a different retirement situation that can help us decide where and how to invest. In general, I suggest all young professional build an “investment snowball.”
First, take full advantage of your employer’s 401(k) match. If you have more to invest after that, put it all into your Roth IRA until it is maxed out. Next, put anything extra into your 401(k) until it is maxed out ($17,000 in 2012 and $17,500 in 2013). After that, put any extra investments into a regular old investment account.
If you are getting closer to retirement (about 50 and above), putting more into a 401(k) might make more sense. You don’t have the long time horizon to grow your investments to take full advantage of a Roth IRA before you retire.
How do you invest for your retirement? What is your system and how do you implement it? Please share your thoughts in the comments.
Image by Phil Taylor PT / flickr