As someone deeply interested in personal finance, I have read my fair share of of 401K versus IRA debates. The facts are out there, but the number of scenario’s involved for each specific persons tax, age, and retirement situation can very greatly. There is no one piece of advice that any blogger or financial advisor can give to the community as a whole. However, I have seen a lot of bad advice out there lately, and I’d like to share with you what I believe is the best utilization of these accounts. I’m going to do my best to keep this as simple as possible.
Investing in a 401K
If you work for a company that provides an employer match for a 401k, then this is the first place you should be looking to invest. If you are a high wage earner then please keep in mind that individuals under 50 are limited to a $16,500 annual contribution. If you are over 50, then you are allowed an added $5,500 annually.
There are only a few instances that warrant you exceeding your employer match. First, if doing so will lower your adjusted gross income enough to put you in a lower tax bracket. Second, you will lower your AGI enough to claim other tax deductions like student loan interest, or medical expenses, etc. Lastly, you are able to fully max out a ROTH IRA account.
Investing in a Traditional IRA
I believe this type of IRA is outdated and we will eventually see it phased out. Individuals under 50 are allowed to contribute $5,000 annually to this type of account, and individuals 50 and over can contribute $6,000 annually. The income limitations on this type of IRA are a little more constricting. In order to receive the tax deduction, you have to earn $66,000 or less as a single filer ($110,000 or less if married). The earnings grow tax-free much like a 401k, and then you foot the tax bill upon withdrawl. The true benefit of this type of IRA is that you have more room to invest money after capping out the $16,500 in your 401k. So if you are fortunate enough to be able to max out the 401k, you can increase your tax benefits in this fashion. Though I’m willing to best that most people within these income limits are probably not maxing out 401k and a traditional IRA.
Investing in a Roth IRA
Much like a traditional 401k, a Roth allows you to invest $5,000 annually each year, or $6,000 annually if you are 50 and over. However, it’s important to note that these are dollars that have already been taxed! So in reality, a $5,000 annual contribution in after-tax money is greater than $5,000 in pre-tax money. The income limits are considerably less, a single filer can fully contribute if their income is less than $107,000 ($169,000 if married). The best part of a Roth IRA, is not only are you essentially contribution more principal to the account, you can withdraw your earned interest and divdends tax free. You only need to be 59 1/2, and you need to have had the account open for at least 5 years. The next best part, you can withdraw your own contributions penalty free at any age after that account has been open 5 years. Making this investment not only great for retirement, but as a house fund, medium-term planning fund, and a college fund.
If you are trying to achieve the maximum tax benefit, and you can afford to do so, then contribute the full amounts to all three types of accounts. If you are trying to save for retirement in the most effective manner, but you are limited in how much to contribute, then always make sure you contribute to your employers match in a 401k. This is free money that you do not pass up. Then provided you aren’t on the brink of the next lowest tax bracket, I would say that you should skip right to the Roth IRA. If possible, this IRA should be fully funded each year. Once you have fully funded the Roth IRA, then it’s time to start considering an online brokerage account. Your next investment should be in a diversified portfolio of mutual funds, ETFs, and dividend paying stocks.
You are going to find a plethora of advice and opinions on this subject. As long as you know your desired annual tax benefit, and the amount of money you can afford to save, then going in the 1-2-3 order I listed above should be sufficient enough to help you determine which account(s) work for you.