401k vs. IRA: Where should you save?
With so many options available, what's the best way to set aside money for retirement? Here's a suggestion.
This post comes from Rob Berger at partner blog The Dough Roller.
For many of us, there are a lot of choices, including a 401k, Roth 401k, deductible IRA, Roth IRA, and a nondeductible IRA. And that's not even counting 403b accounts, SEP IRAs, self-directed IRAs and, of course, taxable accounts.
And if that weren't enough, for many of us the best options are a combination of 401k, IRA and taxable accounts.
Recently I came across a post on the Bogleheads forum (an excellent investing forum) that addressed this question. According to the good folks at Bogleheads -- named after the founder of Vanguard, Jack Bogle -- retirement investing should be placed in the following types of accounts in the order listed:
- 401k/403b up to the company match.
- Max out Roth IRA.
- Max out 401k/403b.
- Taxable investing.
While your situation may be unique, I think the above priority ranking is, as a general rule, quite sound. Here's the rationale behind this list:
A 401k or 403b up to company match. When your employer matches some of your contribution, it's critical to take full advantage of the match. Otherwise, you're just turning away free money. The value of the match makes this the first place to stash your retirement savings. (Post continues below.)
Roth IRA. Once you're saving enough in a 401k to get the company match, additional retirement savings should go to a Roth IRA, according to the Bogleheads. While I think arguments to the contrary could be made here, I like this approach for two reasons.
First, many people assume that taxes will go up in the future. So, unless you are in the top tax brackets today, many recommend paying taxes on the income now and enjoying tax-free growth and retirement distributions later with a Roth IRA. And with retirement savings in both a 401k and Roth IRA, you have some investments that are tax-deferred and some that grow tax-free, which is a nice way to hedge your bets when it comes to future taxes.
Second, with any IRA, you can choose where to open the account. Many 401k plans charge extremely high fees and have limited investment options. For those who like to keep investing simple, Betterment is an excellent option for an IRA (read my review here). If you like to trade, I think Scottrade is a great choice because of low fees and physical branches just about everywhere. However, many brokers offer IRA accounts.
Keep in mind that your income may disqualify you from opening a Roth IRA. You can check out the 2012 Roth IRA limits here.
Max out 401k/403b. Once you've maxed out your Roth IRA, top off your 401k. Keep in mind the limits on contributions, which can change from year to year. For 2012, the contribution limit has been increased from $16,500 to $17,000. The catch-up contribution limit for those age 50 and over remains unchanged at $5,500.
Taxable accounts. Unless you qualify for a SEP IRA, the next and last stop is a taxable account. Here you can open an account with a mutual fund family like Vanguard or Fidelity, open a brokerage account, or use a service like Betterment.
As I mentioned above, every situation is different. The above priority list may not be ideal for everybody. But I think it's a sound way to approach retirement investing.
More on The Dough Roller and MSN Money:
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Careful - while 70½ is the RMD age, you may start withdrawing penalty free at 59½. Depending on your tax bracket, I would encourage you to do so up to the top of your current tax bracket whether you need the money or not. That will give you more flexibility at 70½ by reducing the amount of your RMD. If you don't need the money, you can stash it into a taxable account - prefereably a tax efficient fund such as a low cost index fund that will not "churn" the investment.
$800,000 is not a lot to have in your retirement accounts if you start saving diligently by the time you are 30 and don't do silly things like "trade" your retirement accounts. About $525 per month increased by 3% each year (reasonable wage increase even without any promotions). This is not a small amount for many people, but workable for many if you are committed and this is your first priority. Especially true if you get any kind of employer match.
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