If you get a match, investing enough in your 401(k) to maximize that match should be the first major investment you should make. Once that core is taken care of, however, many 401(k)s lose a bit of their luster. Account maintenance fees, limited investment choices, and somewhat tough withdrawal rules if you need to tap your money early often make a 401(k) a less than ideal choice for your investments.
Indeed, there's a no-brainer retirement account I'd choose way before putting more money into a 401(k). That account is a Roth IRA. Whether I'd be getting money into a Roth IRA directly or via a backdoor contribution, setting a target of maxing out a Roth IRA contribution would be my top priority after getting that 401(k) match.
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Roth IRAs have great flexibility
Many brokers offer fee-free Roth IRA accounts along with commission-free investing within those accounts. When combined with the broad array of investments available in typical brokerage-based Roth IRA accounts, this adds up to most Roth IRAs providing low-cost and high flexibility. On the flip side, typical 401(k) programs charge fees and only offer a limited assortment of investments, which gives Roth IRAs a leg up for money you're investing after you max out your 401(k) match.
Roth IRAs have friendly early withdrawal rules
In addition Roth IRAs offer much friendlier withdrawal rules than other retirement plans. If you need to tap your money before reaching a standard retirement age, you first withdraw the money you directly contributed to a Roth IRA at any time, for any reason -- completely tax and penalty free. After that, you withdraw money you converted to a Roth IRA. Those also come out tax-free, but you may pay a 10% penalty unless the contributed amount has sat in your Roth IRA for at least five years.
It's only after those contributions and conversion amounts are tapped out that you'll be withdrawing earnings from your Roth IRA. While an early withdrawal of earnings may subject you to both taxes and penalties, the fact that earnings are the last thing you withdraw make them friendlier than other retirement accounts.
Roth IRAs are better for retirees, too
If you're a diligent investor inside your retirement accounts throughout your working career, you are likely to build up a decent balance in those accounts by the time you reach retirement age. On that front, Roth IRAs also shine.
Other retirement accounts are subject to something known as Required Minimum Distributions. Those are mandatory withdrawals from the account once you're old enough (currently age 73, but rising to age 75 by 2033). Roth IRAs do not face those required minimum distributions during the original account owner's lifetime.
That allows you to keep the money compounding completely tax free throughout your lifetime as well as enabling you to set your heirs up with a decent and tax-advantaged nest egg once you've passed. In addition, Required Minimum Distributions can raise your taxes and Medicare Part B costs by creating taxable income due to the withdrawals from traditional-style retirement accounts. By avoiding Required Minimum Distributions, Roth IRAs can save you a lot of headache and costs in retirement.
In addition, as long as you've reached age 59 and a half and have had your Roth IRA account funded for at least five years, your withdrawals in retirement are completely tax free. As a result, your Roth IRA can be a very efficient source of money should you need -- or choose -- to tap it to cover your retirement costs.
There's still a place for your 401(k), of course
As awesome as a Roth IRA can be, there is still a place for a 401(k) in your retirement toolkit. First and foremost, if you get a match in your 401(k), contributing enough to maximize that match is still the first investment you should make.
In addition, Roth IRA contributions are limited to $6,500 per year if you're under age 50 or $7,500 per year if you're age 50 or up. Unless you start really early in your career and invest both consistently and successfully throughout it, that may not be enough on its own to fully fund your retirement. The much larger contribution limits that 401(k)s provide ($22,500 for those under age 50, $30,000 for those aged 50 and up) make them a great tool to help you reach for your goals faster.
Build a strategy to get your retirement plan on track today
Put it all together, and you end up with a great strategy for funding your retirement.
- First, contribute enough to max out your 401(k) match
- Then, get as much as possible inside a Roth IRA
- Finally, go back and put more into your 401(k) until you're either on track or maxing it out
That strategy gives you the no-brainer benefits of a Roth IRA while giving you a better shot of being able to save enough to reach retirement with a decent nest egg to support you. Get started now, and make today the day you get on track for a more comfortable future.
