Should You Max Out Your 401(k) or Your Roth IRA First?

Financial planners say that you should aim to contribute at least 15% of your pre-tax income to saving for retirement but weighing exactly what kinds of accounts to put your money in, and when, can be paralyzing. Fortunately, there's a rule of thumb for optimizing two kinds of accounts—a 401(k) and Roth IRA or Roth 401(k)—that makes sense for most people.

What Is the Rule of Thumb for Investing Retirement Savings?

Contribute as much you can from your paycheck to max out the match if your employer offers a 401(k) match. This may take some time but focus next on Roth IRA contributions after you've met that goal and you're meeting your employer's match on a regular basis. Then go back to your 401(k) and withhold more from your paycheck if you max out your Roth IRA. Keep at it until you've reached the annual limit for employee contributions.

How To Use This Retirement Savings Rule of Thumb

This rule of thumb ensures that you'll take advantage of company matching upfront, then it allows you to make additional retirement contributions where you get the best tax benefits. Following a specific set of steps for a long-term plan keeps you on track and eliminates the need to refigure your plan every year.

Get Your 401(k) Match

The 401(k) is an employer-sponsored retirement account to which employees can contribute pre-tax salary. As the account grows, gains on investments are tax deferred until the money is withdrawn. Many employers will match at least some portion of their employees' 401(k) savings, which means you'll get free money for your retirement.

Let's say that your employer offers to match 50% of your contributions, up to 3% of your annual salary. That means that your employer will kick in an additional 3% ($3,000), bringing your total retirement savings to $9,000 a year if you earn $100,000 a year and contribute 6% ($6,000) of it to your 401(k).

Your employer's matching contributions are only yours if you stay with the company for a certain period of time. You'll lose some or all of the matched contributions if you leave before your 401(k) is vested. Your own contributions are always yours.

Check with your human resources department or review a copy of your employee handbook to find out about your company's 401(k) matching program. With this information, you can calculate the amount you need to contribute to get the full match.

Fund Your Roth IRA

Once you've earned the full company match on your 401(k) contributions for the year, focus on maxing out annual Roth IRA contributions if you're eligible. Due to the lack of income limitations, you should fund the Roth 401(k) before attempting to contribute to the Roth IRA account if a Roth option is available in the 401(k).

A Roth IRA allows you to make post-tax contributions, but you won't pay taxes on gains, including dividends, capital gains, and interest earned. The sooner you get your money into the Roth, the longer it will have to compound tax free. You can save up to $6,000 in a Roth IRA in 2022, or $7,000 if you're age 50 or older by the end of the year. This increases to $6,500 (or $7,500 if you're age 50 or older) in 2022. Contribute the maximum every year if you can afford it.

The Roth IRA also offers flexibility to avoid additional taxes on certain distributions before retirement. You can withdraw money to purchase your first home (with limitations) or for certain medical expenses without incurring the usual 10% tax on early distributions. These exceptions make the Roth IRA a vehicle that you could draw on for a down payment or for an emergency if you didn't have other savings.

Return to the 401(k)

You can contribute a maximum of $20,500 to your 401(k) in 2022, increasing to $22,500 in 2023. Employees who are over age 50 can make an additional $6,500 catch-up contribution. Go back to your 401(k) and contribute any additional amount you can this year once you've made enough 401(k) contributions to meet the company match, and you've reached the annual Roth IRA contribution limit.

You won't get an additional company match on these extra contributions, but you'll still make pre-tax contributions to your retirement savings.

Why This Rule of Thumb Generally Works

This rule of thumb works for most people because it first prioritizes maxing out the employer match to make sure you don't miss out on free money. Then it prompts you to get your money into the Roth IRA so the money has the maximum amount of time to grow tax free. Finally, you can stash more funds in your 401(k) and get additional tax benefits, up to the annual limit, if you can afford to make additional retirement contributions.

It's a straightforward plan that takes the guesswork out of retirement savings.

A Grain of Salt: Roth IRA Contribution Limits

Not everyone can spare the money needed to fully max out two or more retirement accounts, so you might not achieve all the steps of this plan. You'll still want to follow the order of the priorities laid out in the rule if that's the case for you, but you might not be able to max out your 401(k) in Step 3 above.

Another thing to keep in mind is that the Roth IRA contribution limits are lower for high earners. Single filers and heads of households can make the full contribution if their modified adjusted gross income (MAGI) is below $129,000 in 2022. A reduced contribution is allowed if you earn between $129,000 and below $144,000. You can't contribute to a Roth IRA if your MAGI is equal to or above $144,000.

These thresholds are also indexed for inflation, and they increase in 2023. Single and head of household filers can make the full contribution on incomes of less than $138,000. They can make a reduced contribution on incomes from $138,000 to $153,000 and they can no longer contribute if they earn $153,000 or more.

Although there are limitations based on level of income when contributing to a Roth IRA, you can still contribute to a Roth 401(k) if the option is available in the 401(k) offered. The level of income would not be a barrier to saving in an after-tax account.

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