Why You Should Consider Contributing to Both a 401(k) and a Roth IRA
If you’re already contributing to your employer’s 401(k), you may think that you’ve taken care of your retirement savings. However, it’s important to continue building your retirement fund if you can afford to do so. One effective strategy is to match a 401(k) with a Roth IRA, as it allows you to diversify your savings and take advantage of different tax benefits and withdrawal options.
Differences between 401(k) and Roth IRA
A 401(k) and a Roth IRA have significant differences in terms of how you can benefit from each account. Here are the key points to consider:
How you qualify
A 401(k) plan requires an employer to offer it, while you can open and establish a Roth IRA on your own as long as your income qualifies. High-earners can also contribute indirectly through a backdoor Roth IRA.
Minimum deposit and balance
The minimum deposit and balance requirements may vary depending on the investment vehicle selected. For example, Charles Schwab has no account minimum for active investing through Schwab One® Brokerage Account, while Betterment doesn’t require a minimum investment account balance.
Fees
Fees may vary depending on the investment vehicle selected. Schwab One® Brokerage Account has no account fees, while Betterment’s fees depend on the investment vehicle selected and account balances.
Investment options
Both Charles Schwab and Betterment offer a variety of investment options, including stocks, bonds, mutual funds, CDs, and ETFs.
The tax advantages
A traditional 401(k) allows for tax-deferred contributions, meaning you don’t pay taxes until you withdraw the funds. On the other hand, a Roth IRA requires you to pay taxes upfront, but withdrawals are tax-free.
The Roth 401(k)
In addition to a traditional 401(k), some employers offer a Roth 401(k) option. Contributions to a Roth 401(k) are taxed, but distributions are tax-free.
Withdrawal rules
You can withdraw contributions from a Roth IRA at any time without paying tax or penalties. With a 401(k), early withdrawals before age 59.5 typically incur penalties and taxes, though there are exceptions.
Contribution limits
A 401(k) and a Roth IRA have different annual contribution limits. For 2023, the 401(k) limit is $22,500, or $30,000 if you’re 50 or older, while the total IRA limit is $6,500, or $7,500 if you’re 50 or older.
Why contribute to both 401(k) and Roth IRA
If you can afford it, contributing to both a 401(k) and a Roth IRA allows you to maximize your retirement-saving options. With a 401(k), you get an immediate tax break, while a Roth IRA guarantees a tax break in the future. This setup helps spread your tax liability and provides tax diversification, considering the uncertainty of future tax brackets.
A Roth IRA also offers more flexibility in accessing your contributions before retirement, compared to a 401(k). Additionally, the contribution limit for a Roth IRA is lower than that of a 401(k), so having both accounts allows you to save more overall.
How much to contribute to 401(k) and Roth IRA
If you have both a 401(k) and a Roth IRA, it’s generally advised to prioritize contributing enough to your 401(k) to meet any employer match. For the remaining amount, follow the rule of thumb of putting 10% to 15% of your pre-tax income (including employer matches) into all of your retirement savings accounts.
For example, if your employer matches up to 6% of your salary, contribute 6% to your 401(k) to take full advantage of the match. Then, contribute the remaining amount (up to 15% in total) to your Roth IRA.
By diversifying your retirement savings through both a 401(k) and a Roth IRA, you can maximize your savings potential and take advantage of different tax benefits, withdrawal rules, and contribution limits.
