Building your retirement nest egg requires the right strategy as much as it requires extra cash. Part of that strategy involves choosing the best place to keep your savings. Each account has its own set of rules, contribution limits, and investment options that could affect how useful it is to you.
Sometimes, an account offers rare benefits you can't find anywhere else. This is the case with two of the most popular retirement savings vehicles -- 401(k)s and Roth IRAs. Here are a few questions you can ask yourself to decide which one is right for you.
Image source: Getty Images.
Which account(s) are you eligible for?
There isn't a debate about which account to use if you don't have access to one of them. For a 401(k), you need an employer that makes this option available to its employees. If your company doesn't offer one, you may have no choice but to save in an IRA or other retirement account.
Roth IRAs are open to most people, but high earners can't contribute to one directly. However, they can do a backdoor Roth IRA. This is where you put money in a traditional IRA and do a Roth IRA conversion in the same year. It's a little more time-consuming, but it achieves the same goal.
Does your 401(k) have a match?
It's generally wise to put your savings into a 401(k) first if you qualify for a match. If you skip this, you'll lose that extra money. Even if you think a Roth IRA is a better choice for your savings, stick to your 401(k) until you've claimed your full match for the year, then switch.
Talk to your company's HR department or your 401(k) plan administrator if you're unsure how much you need to set aside to earn your match. Then, adjust your contributions accordingly.
The only times you may not want to do this are when you need all your savings to cover your living expenses today, or you don't plan to remain at your company long. In the former case, diverting money to retirement savings could cause financial problems today. And in the latter, you could lose your match anyway if you quit your job before you're fully vested. In these scenarios, you may prefer to toss money into your Roth IRA as you're able to do so rather than withholding money from each paycheck.
Which account will give you the greatest tax advantages?
Most 401(k)s are tax-deferred, which means that contributions to them reduce your taxable income for the year. But in exchange, you owe taxes on your money when you withdraw it later. This could be advantageous if you expect your income to drop significantly in retirement. By waiting to pay taxes, you may owe the government a smaller percentage of your money than you would if you paid taxes upfront.
Roth IRAs, on the other hand, don't give any sort of upfront tax break. But since you pay taxes on your contributions when you make them, you can also withdraw these funds tax-free at any time. And you can withdraw earnings tax- and penalty-free once you've had the account for at least five years and are at least 59 1/2 years old. One of these accounts could save you quite a bit if you expect your income to remain about the same or increase in retirement.
Though less common than the accounts above, some employers now offer Roth 401(k)s. If you have access to one of these, it could be the perfect compromise between the two. You get the high contribution limits and the potential to earn an employer match common to 401(k)s as well as the tax-free withdrawals of a Roth IRA.
Which account offers better investment options?
One of the best things about Roth IRAs -- and IRAs in general -- is that they enable you to invest in virtually anything you want. 401(k)s, on the other hand, typically restrict you to a set of funds your employer chooses. Sometimes these options might suit you fine, but other times they can be costly and may not match your risk tolerance.
If you're unhappy with your 401(k)'s investment options, you may prefer to put money into your Roth IRA first. You can stash up to $6,500 here in 2023 or $7,500 if you're 50 or older. If you max this out, you can return to your 401(k). You're allowed to put up to $22,500 here in 2023 or $30,000 if you're 50 or older, so between the two, you should be able to save a good amount.
You don't have to choose one over the other
Saving in a 401(k) or a Roth IRA doesn't mean you can't use the other type of account at all. Use your answers from the questions above to determine where it makes sense to place your money first. But feel free to adjust your strategy over time.
For example, you might put money in your 401(k) first to get your company match. Then, you could switch to a Roth IRA. And if you max that out, you could switch back to your 401(k) for the rest of the year. Find the approach that works best for you, and then decide how much you want to contribute to each account going forward.
