One of the most common questions we get asked by budding investors is how much they should contribute to their 401k plan; more specifically, should they be contributing more?
For most, the 401k is going to be a first introduction into retirement planning, and you want to make sure you’re doing everything you can with that before tackling things like mutual funds and brokerage accounts on your own.
There’s no one right answer. It really depends on your tax bracket, the amount your employer contributes and your discretionary income, but you will likely identify with one of those categories.
First, max out your match
Let’s start with the obvious: Are you contributing up to the maximum percentage that your employer matches in your 401k? If not, that’s the first thing you need to address. There’s no better bargain than someone else matching your investment funds dollar for dollar.
But let’s say you are taking advantage of the full match – in most cases it will represent between 3 and 5 percent of your annual salary – what’s the next step?
If you’re eligible, look at a Roth IRA
Two big drawbacks to 401k plans are the limited investment choices they give to you and the fees some charge. IRAs and Roth IRAs offer much better fund options and allow you to diversify and manage your risk tolerance — and the fees you pay — more efficiently.
You have probably heard that a Roth IRA is a better plan than a traditional IRA, but may not know why. It’s simple: Traditional IRAs allow for an up-front tax deduction, but tax you on the back end when you withdraw funds whereas the Roth IRA taxes you now, thus allowing you to withdraw tax-free when you hit retirement age. Since you will most likely be in the workforce for the next 25 plus years, your income is at the lowest level of your career so paying taxes now isn’t much of a burden.
Sounds great, right? Why wouldn’t everyone just get a Roth IRA after hitting their 401k match?
Believe it or not, there is such a thing as making too much money – as far as the IRS is concerned anyways. As of 2013, if you’re single making more than $127,000 per year or married making more than $188,000 per year, you are no longer eligible to contribute to a Roth IRA. Bummer. But hey, with that extra income (if you’ve been vigilant in your lifestyle) you now have more discretionary income available.
If not, keep pumping the 401k
Back to square one — you have two possibilities for investment contributions: IRA or 401k. Even though the 401k has fewer investment choices available, it’s still the better deal.
The IRA will always allow tax-deferred growth in the account, you’ll pay those taxes when you withdraw, but it might not give you an upfront tax deduction anymore. The 401k will still invest your money pre-tax even though your employer won’t match the extra you put in there. The 401k also has much higher contribution limits – $17,500 as of 2013 versus $5,500 for an IRA.
Let’s do a quick recap:
- Make 401k contributions up to maximum employer match
- Determine whether you can contribute to a Roth IRA
- If yes, contribute up to maximum allowable amount ($5,500) to Roth IRA
- If no, contribute more to your 401k until you max out at $17,500 annually
Some employers offer a Roth 401k to employees, but the same rules apply as with the Roth IRA. You should contribute as much as you can to the Roth accounts first unless you exceed the income limitations placed on them by the IRS. Another thing to keep in mind is that IRAs can be converted to Roth IRA accounts at any time, although you will not be able to place any additional funds into the Roth once it’s converted over. You’ll have to pay taxes to convert the retirement accounts over, but then the funds can be withdrawn tax-free once you hit the retirement age of 59 ½.