It’s almost always a good idea to take advantage of employer matching funds using your 401(k) plan. After that, you need to decide whether it’s better to do additional saving in your 401(k) or switch to a traditional or Roth IRA. Here’s how to prioritize saving in a 401(k) and IRA.
Get the match. Many companies match your contributions to the 401(k) plan, which is extra pay from your employer that you shouldn’t miss out on. This is an instant return on your investment.
Automatic deductions. A major advantage of your 401(k) plan is that the contributions come out of your paychecks before the tax is calculated and you won’t have to pay tax until you withdraw the money from the account. Making your deposits automatic can help you to save more for retirement.
Contribution limits. You can defer taxes on far more within your 401(k) than in an IRA. The maximum 401(k) contribution for 2012 is $17,000. And workers age 50 and older can add another $5,500 in catch up contributions. Traditional and Roth IRAs have the much more modest contribution limit of $5,000 in 2012, or $6,000 if you are age 50 or older.
Investment options. IRAs typically have far more investment choices than most 401(k) plans. You can generally invest in a large variety of funds in an IRA account, while in 401(k) accounts you are usually limited to a few mutual funds.
Tax treatment. Traditional 401(k) and IRA contributions give you a tax break in the year you make the contribution, but income tax is due on each withdrawal. Contributions to Roth accounts are made with after-tax dollars, but you won’t have to pay income tax on withdrawals in retirement. Another major benefit of the Roth IRA is that you can withdraw the contribution amount, but not the earnings, at any time with no penalty.
It’s best to max out both your 401(k) and IRA accounts every year, but many of us do not have the resources to do this. Most Americans probably can’t spare $22,000 to contribute the maximum amount to both types of retirement accounts. If you can’t invest a lot of money, your first priority should be to invest enough to get the full 401(k) match from your employer.
After receiving the full company match, it is a little more difficult to decide whether to invest in a 401(k) or Roth IRA. A key consideration is minimizing your tax rate. If you currently have a low tax rate, then you should try to pre-pay income tax using a Roth IRA in case your tax rate increases in the future. If you are in the 25 percent or higher tax bracket, then you might want to take the tax break now by contributing to a traditional 401(k), especially if you think you will drop into a lower tax bracket in retirement.
Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.