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Why You Should Max Out Roth IRA Contributions Before Your 401(k)

By Stefon Walters – Updated Oct 21, 2021 at 7:22PM

Key Points

  • 401(k)s give you set investment choices to choose from.
  • Most Roth IRAs don’t have management fees.
  • You can withdraw contributions, but not earnings, from your Roth IRA without incurring a penalty.

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Put yourself in a position to get the most from your retirement accounts.

When it comes to saving for retirement, one of the most important things you can learn is how retirement accounts differ. One of the primary differences between retirement accounts is the limit on contributions you can make. While maxing out your retirement contributions is a good thing, here are four reasons why you should consider maxing out your Roth IRA contributions before your 401(k).

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Freedom to invest your money where you like

With a 401(k), your employer and plan provider present you with your investment choices. These choices typically include the company's stock (if they're a public company), funds put together based on market capitalization, and target-date funds -- which you select based on your projected retirement year.

On the other hand, Roth IRAs function like brokerage companies in that you can choose which investments you want, whether that's single companies or funds. Having this freedom gives you more control over your investment decisions.

401(k) fees can be expensive

Depending on the size of your 401(k) provider, your management fees can reach up to 2% annually, or $20 per $1,000 invested. On top of the management fee, investors must also pay the specific fee charged by the fund(s) inside the 401(k) account.

In most Roth IRAs, there's no management fee to pay; you're only responsible for paying the fee charged by any funds you may purchase. Or, you could even get by with paying no fees if you only invest in single companies. Although a couple of percentage points in fees may not seem like much on paper, over time, they eat away at your returns and can cost you thousands of dollars.

For example, let's assume you contribute $500 monthly to your Roth IRA account at 10% annual interest. In 30 years, you would have accumulated around $986,960, thanks to compound interest. If you did the same thing in a 401(k) with a 2% management fee, you would only have around $679,700 at the end of those 30 years. 

Although you personally contributed $180,000 in both scenarios, a 2% difference added up to more than a $300,000 difference.

Roth IRAs have income limits

Unlike a 401(k), a Roth IRA has income limits for those eligible to contribute.

Filing Status

Income

Contribution Limit

Single or head of household

Less than $125,000

$6,000 ($7,000 if age 50+)

$125,000 to $139,999

Varies

$140,000+

$0

Married, filing jointly

Less than $198,000

$6,000 ($7,000 if age 50+)

$198,000 to $207,999

Varies

$208,000+

$0

Married, filing separately

Less than $10,000

Varies

$10,000+

$0

Because of the tax benefits Roth IRAs have -- such as the ability for your money to grow tax-free -- you might want to take advantage of it while you're still eligible.

Roth IRAs have more lenient withdrawal rules

Withdrawing money from your 401(k) before you're 59 ½ years old generally leads to income taxes being owed and a 10% early withdrawal fee. Depending on how much you plan to withdraw, this can be a costly move.

Because you contribute after-tax money to your Roth IRA, you can withdraw your contributions -- but not earnings -- at any point without facing any additional taxes or penalties. Roth IRAs also have a five-year rule that allows you to withdraw your earnings tax-free five years after your first contribution to a Roth IRA. The five-year timer begins the first day of the tax year of your contribution, so if you contributed money mid-2021 for tax year 2021, your five years would be up on Jan. 1, 2026.

An ideal path to follow

If you're wondering how you should go about contributing to your retirement accounts, this method can provide be a good baseline to use:

  1. Contribute up to your employer match: If your employer matches any amount of 401(k) contributions, you should aim to always contribute at least that much at bare minimum. Contributing anything less than the match is essentially leaving free money on the table.
  2. Max out your Roth IRA contributions: Roth IRAs are tax-friendly and have income limits, so while you may still be eligible, you'll want to contribute as much to your Roth IRA that's allowed, assuming it's financially possible for you.
  3. Return to your 401(k): Roth IRA max annual contributions are relatively low compared to 401(k)s, so if you manage to max out your Roth IRA, you should return to your 401(k) and contribute as much as you can.

If you follow that method, you'll put yourself in a great position to maximize the benefits that each respective retirement account provides. Your future self will thank you.

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