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Should you prioritize investing in your 401(k) or your Roth IRA?
The IRS will allow you to save money in both your 401(k) as well as your personal Roth IRA. There are limits to how much you can save. In addition, if your income exceeds certain amounts you cannot make contributions to the Roth IRA.
Whether you should prioritize your Roth or your 401(k) depends on a few variables.
First, let’s examine a few features of both investment vehicles…
401(k)
- Contributions are tax-deductible for the tax year in which they are made (i.e. if your taxable income is 100k and you contributed 10k, now your taxable income is only 90k).
- Contribution limit is $15,500 for 2007.
- Investment grows on a tax differed basis, meaning no taxes are due while the money remains in the 401(k). There are however required minimum distributions that begin at age 70-1/2.
- Withdrawals are fully taxable at your current income tax rate at the time of the withdrawal. For example, if you begin taking 40k out per year, at age 65 you have just created 40k worth of additional taxable income.
Roth IRA
- Contributions are made on an after-tax basis, meaning you cannot deduct them from your current taxable income
- Contribution limit is $4,000 per year, increased to $5,000 per year if you are age 50 or older.
- Investment grows on a tax differed basis
- Withdrawals are completely tax-free when taken. This means that if you withdrawal 40k per year, it will not be taxed if it comes from your Roth.
What Should You Prioritize First?
- If your 401(k) has a match, then you should contribute to the 401 first — up to that matching percentage. Remember, the match is free money. There’s nothing like a guaranteed 100% rate of return!
- Next, you should max out your Roth IRA (if you are married filing jointly and your adjusted gross income is above $166,000 you cannot contribute to a Roth, filing single the limit is $114,000).
- Lastly, if you still want to save more money, go back to the 401(k) and finish maxing it out!
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