Should You Max Out Your 401K before Investing in a Roth IRA

I read a great article comparing 401ks and IRAs  at Cash Money Life the other day and I wanted to expand on one of its key elements:

Roth IRAs are non-deductible, which means you use post-tax money to fund your account. However, the distributions made during retirement age are tax exempt, which is the main reason people invest in a Roth IRA.

Are average investors really doing the right thing by investing in ROTH IRAs?

If your company matches your 401k contributions up to a certain percentage of your salary it makes sense to invest at least enough to get the full company match. The question is, should you contribute more to your 401K (above the matching percentage) or should you open a ROTH IRA and fully fund it before resuming contributions to your 401K?

If you listen to personal finance guru’s like Dave Ramsey and Suze Orman, they repeatedly tell you to invest enough to get your company’s 401k match, then max out a Roth IRA and only then (if there is any money left over) invest any additional money you can in your company’s 401K up to the maximum annual contribution limit (currently $17,000).

The theory is the money in the Roth IRA will grow “tax free” and you won’t have to pay taxes on it when you withdraw the money in retirement. The caveat is that you pay taxes on the money before you put it in the ROTH IRA.

On the flip side, money you put into a traditional 401K account is not taxed before it goes in the account and you receive the benefit of a lower tax bill now (instead of later in retirement). This drawback here, or course, is that you WILL pay taxes on 401K proceeds when you withdraw the money in retirement.

And so begs the inevitable question:

Is it better to Pay Taxes Now through a Roth IRA or Pay Taxes Later through a Traditional 401K Plan?

The truth is, if your tax rate remains the same now as it does in your retirement years, the “real” value of your retirement savings is EXACTLY the same.

Example: Lets say you have an extra $10,000 per year above what you’re putting in your 401K to get the company match. You plan on retiring in 30 years and you want to know if you should invest your money in a ROTH IRA or a Traditional 401K. Which option will save you the most money on taxes over time?

ROTH IRA Scenario:
You invest $10,000 per year in a ROTH IRA for 30 years assuming an average annual return of 8%, and a tax rate of 25%. Because of the 25% tax rate, you would actually only be contributing $7,500 per year (after tax dollars) into the ROTH IRA. After 30 years your retirement account would grow to $849,624.08.

Traditional 401K:
You invest $10,000 per year in a traditional 401K for 30 years assuming the same average annual return of 8% and a tax rate of 25%. Your account grows faster because you are contributing the full $10,000 each year (before tax) into the traditional 401K, the difference is you’ll be responsible for paying taxes on the money when you withdraw it. After 30 years your 401K retirement account would grow to $1,132,832.11.

All other things being equal, 25% tax on $1,132,832.11 leaves us with$849,624.08, the exact same amount you’d have if you invested the money in a ROTH IRA.

What Will Your Tax Rate Be in Retirement?

As you can see from our case study example, our decision to invest in a Roth IRA vs. a Traditional 401K really comes down to what you think your tax rate will be in retirement.

If you think your tax rate will be lower in retirement (like I do), it makes sense to invest your money before taxes are taken out in a retirement account like a Traditional 401K or Traditional IRA.

If you think your tax rate will be higher in retirement, it makes sense to invest your money in a ROTH IRA or “Roth 401K” if your company sponsors one.

The way I see it, if I’m making more money in retirement than I am working (putting me in a higher tax bracket), I’ve done some serious over-saving for retirement. That would mean in the few years leading up to retirement I could actually retire and make just as much money. That just doesn’t seem practical to me, especially considering my living expenses should be considerably lower in retirement (mortgage paid off, kids off on their own, etc.).

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