We recently had the pleasure to work with a couple who were early in their careers, and in fields with the potential to make considerably more money. The husband was adamant about saving to a Roth IRA because he wanted tax-free income in retirement. He knew that they had a limited window to save to the Roth since they were still under the income limit. The wife preferred to save to her 401(k) through work because she knew she had the potential to save more because of the higher contribution limit. So, who is right?
Both of them are. When we talk about diversification in your portfolio, it means several things. It can mean a diverse selection of investments like stocks, bonds, and real estate. It can also mean market capitalization, with a mix of Small-Cap, Mid-Cap, and Large-Cap stocks. It also means owning a variety of stocks across the different market sectors. One part of diversification that many people overlook includes diversification of tax treatment.
Funds saved to a Roth IRA are after-tax funds, and they enjoy tax-free growth. Distributions in retirement are tax-free. Funds saved to a 401(k) are pre-tax and enjoy tax-deferred growth. Distributions in retirement are taxed at ordinary income rates. So, a $1 million Roth IRA is worth $1 million; however, a $1 million 401(k) is worth less because tax is owed when funds are withdrawn.
We don’t know what tax rates or even tax laws will be in the future. The best an investor can do is take advantage of what is available today.
We first recommend making sure an investor takes advantage of any employer matching contributions that are offered through the 401(k). As incentive for participation, many employers match employee contributions up to a certain percentage of salary. You’ve heard us say it before: it is free money. Even if you put your employee contribution in a money market fund with no growth, the employer match can significantly increase the value.
Once the investor has contributed enough to receive any available matching contributions, then they can invest in their Roth IRA while they are under the income limits. For 2019, an investor who is married filing jointly can contribute $6,000, if their modified adjusted gross income is less than $193,000. The contribution amount phases out as their income reaches $203,000. No contribution is allowed if their income is more than $203,000.
If our example couple truly has earning potential beyond $203,000, contributing to Roth IRAs now may be a good idea. The Roth IRA allows investors to withdraw contributions at any time or any age without penalty. If this couple saved aggressively, knowing they have access to their contributions for an emergency or change in priorities, might be beneficial.
Once they max out their Roth IRA contributions or earn above the income limitations, saving to the 401(k) is still an excellent option. 401(k) plans allow investors to contribute up to $19,000 regardless of how high their salaries go. Because contributions are pre-tax, contributions to the 401(k) will lower their tax bill today.
If you have questions on choosing the appropriate retirement account for you, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
This article is for demonstrative and academic purposes and is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
