401k’s and IRA’s (both Roth and Traditional) are very valuable tools to minimize taxes and are important for every adult to understand as soon as possible.
How do they work? If you’re familiar, you can skip this section, but they all work differently and have different pros and cons. So depending on you situation, one may be better to one over the other. There is no one size fits all.
Traditional 401k:
Pros:
You don’t pay tax on money you contribute (now). This gives you more money available to invest now.
Cons:
You pay normal income taxes when you withdraw. (You don’t get long term capital gains tax rates for money in a 401k.)
You can’t withdraw until you’re 59.5 without a 10% penalty
Limits:
$19.5K under age 50, $25K ages 50-59.5 + Employer match (shared with Roth 401k)
Roth 401k:
Pros:
You don’t pay tax on any money you withdraw (when you’re 59.5)
You can withdraw initial contributions (not gains) at any time for any reason, and you don’t have to pay additional taxes on that money.
Cons:
You pay normal income taxes on the money you contribute (now)
You can’t withdraw gains until you’re 59.5 without a 10% penalty
You pay taxes now, so you’re left with less money to invest. (ie: you make $100 and invest it all vs you make $100 but have to pay $25 in taxes, so you only have $75 left over to invest. It costs more to invest since you have to first pay income taxes on the money)
Limits:
$19.5K under age 50, $25K ages 50-59.5 + Employer match (shared with Traditional 401k)
Traditional IRA:
Pros:
You don’t pay tax on money you contribute (now)
Cons:
You pay normal income taxes on the gains when you withdraw them (when you’re 59.5)
You can’t withdraw until you’re 59.5 without a 10% penalty
Limits:
$6K under age 50, $7K ages 50-59.5 (shared with Roth IRA)
Roth IRA:
Pros:
You don’t pay tax on money you withdraw (when you’re 59.5)
You can withdraw initial contributions (not gains) at any time for any reason, and you don’t have to pay any taxes on that money.
Cons:
You can’t withdraw gains until you’re 59.5 without a 10% penalty
You pay taxes now, so you’re left with less money to invest.
Limits:
$6K under age 50, $7K ages 50-59.5 (shared with Traditional IRA)
So here is how my 401k match works. I get a 100% match on the first 3% of my income. Then I get 50% on the next 2%. So if I save 5% of my income into a 401k, my job will give me 4% of my total yearly income and put that into my account for retirement.
This is free money.
There is no reason ever to not take this. Even if you plan on withdrawing it and taking the penalty (which I don’t recommend), you still come out ahead by contributing up to the match vs none at all. It’s literally free money.
If you think your income now is higher than it will be in retirement, traditional accounts make more sense. However, if you; like me, plan to have passive income streams when you retire, Roth is probably more useful. Since you don’t have to pay taxes when you withdraw, Roth is better if you are in a lower tax bracket right now than you plan to be in the future. Also keep in mind that tax rates may change by the time you retire, so it might be better to pay the taxes now (Roth) or hope they go down in the future and pay them then (Traditional).
Let’s go over the order you should contribute, then we’ll talk about how much you should contribute.
In my opinion, the first thing you should do is contribute to your 401k up to the amount that gets you the maximum match from your company.
The next thing you should do is max your Roth or Traditional IRA.
If you think you’re going to make more now then you are when you retire, max your Traditional IRA. If you think you’re going to make more in the future, max your Roth IRA. For me, I choose to max my Roth IRA.
Remember that with your Traditional IRA, tax brackets can change in the future and cause you to receive less money than you may have planned for. While it’s also true that taxes may go down, history shows that’s very unlikely to happen. By using the Roth IRA, you lock in the rates now, and don’t have to worry about them again. I will personally be using the Roth IRA, since it also offers the flexibility of being able to withdraw my contributions. If you’re unsure, you are always able to take advantage of both accounts and contribute, say, $3,000 to each of them, to hedge your bets. After you max your IRA, your only option is to go back to your 401k… or is it?
At this point, it becomes much more situation specific. I recently posted a comment on the Daily Discussion Thread of the Financial Independence subreddit. The comment was simply asking how much I should be saving, given my age, situation, etc. I wanted some perspective from the experts. Well, there weren’t so nice. I received 22 down-votes before I decided to delete my comment in shame, and the only responses told me to make sure I got my 401k match… which I specifically addressed I was already doing in my comment. Those meanies took my internet points away from me and didn’t even read my comment 🙁
Well, whatever, it’s not a big deal…
Ok, fine, maybe they didn’t have time to read it. Anyway, my situation is a bit different from most. I personally believe that having access to money right now is extremely important. If you are able to see money in an abstract way, and aren’t worried about impulsively blowing the money on a new car, or gambling on stock options, (oops) having money on hand opens a huge number of opportunities.
Personally, I plan to save 10% of my income in a traditional 401k, max my Roth IRA (another 10%), and save another 20% in a taxable account.
By splitting my money like this, there is a lot more risk, but also a lot more potential reward. While I wouldn’t mind retiring with something like $1.5M, I’d like to have as many options as possible, and being able to fatFIRE if I want seems nice too. I’d actually be totally fine living frugally, but I’d love to have the option of going on a vacation twice a year, you know?
2022 Update: Now that I am no longer working a W-2, Roth IRA is really my only option for tax-advantaged accounts. So I’m currently only contributing to that for my retirement accounts. The rest is going into my normal broakrage acounts.