When I first started saving for retirement nearly a decade ago, my employer's 401(k) seemed like the logical place to start. But my company didn't match contributions.
I only had a couple hundred dollars a month to invest. So for me, the choice was simple: I'd skip the 401(k) and invest in a Roth IRA instead.
Of course, if I'd gotten a company match back then, I would have prioritized my 401(k) to get every dollar I could out of my employer. But since we were talking about unmatched contributions, the Roth IRA was the clear winner. Here's why choosing a Roth IRA over an unmatched 401(k) is a no-brainer.
Why a Roth IRA beats an unmatched 401(k)
Let's be clear: I'd always recommend contributing enough to get your full 401(k) match out of your employer. But once you've gotten your match -- or if your company doesn't match 401(k) contributions -- I'd suggest prioritizing your Roth IRA.
The first thing I love about Roth IRAs is that the account belongs solely to you. It's not tied to any employer. Sure, you get to keep your 401(k) money when you change jobs. But you'll often have to deal with a 401(k) rollover unless you're willing to keep track of retirement accounts with multiple employers.
With a 401(k), your investment options are also somewhat limited. But with a Roth IRA, you can invest in virtually any stock, bond, mutual fund, or exchange-traded fund that you choose.
But perhaps the biggest appeal of a Roth IRA is the flexibility. A Roth IRA is meant for retirement, but you can withdraw your contributions at any time without penalty. (If you withdraw the earnings portion before age 59 1/2, you'll owe income taxes and a 10% penalty.) I hope I never have to withdraw from any retirement account before I'm 59 1/2, but if a financial disaster depleted my emergency fund, my Roth IRA contributions could provide an extra safety cushion.
Finally, there are the tax benefits. You don't get a tax break on your contributions, but your withdrawals are completely tax-free in retirement. Given that small amounts of money can grow into a serious nest egg given enough time in the market, I'd rather forgo the tax break now so that the IRS can't touch my earnings later on. (Note that this feature is no longer unique to Roth IRAs, though, as most 401(k) plans now offer a Roth option.)
When should you make unmatched 401(k) contributions?
For most people, the best way to save for retirement is in this order: First, get your full employer match. Then, max out your Roth IRA. Then, make unmatched 401(k) contributions. Or if you want greater flexibility with your money and investment choices, you could invest the extra funds in a taxable brokerage account.
Suppose you make $60,000 and your goal is to invest 20% of your salary, or $12,000 total. Your employer offers a 4% 401(k) match, so you'd invest $2,400 in your 401(k).
Next, you'd aim to max out your Roth IRA. Assuming you're younger than 50, you can contribute up to $6,500 in 2023. (People 50 and older can contribute an extra $1,000).
From there, you'd have $3,100 to invest. You could put that money in your 401(k) or invest it in your brokerage account.
Whatever account you choose for retirement savings, the most important thing is just getting started. If you start early and consistently invest 10% to 15%, your money will grow into a sizable nest egg regardless of what type of account it's invested in.