Should I Fund My 401(K) Or IRA?

If your employer offers a match to your 401(k) contributions, then your first priority should be to contribute enough to the 401(k) to maximize the match. Fewer companies are matching these days, and it may be a benefit on the way out, but as long as it’s there, take advantage of it. It’s free money; don’t leave any on the table.

The next step depends on whether you’re eligible for a Roth IRA. The beauty of a Roth is that you never have to pay tax on it again. All that money you’re stashing in your 401(k) will be taxed at whatever your tax rate is in retirement. Having money in both pre-tax and post-tax accounts provides a hedge against tax increases.

Roths also let you have more control over how your money is invested; you’re not limited to the options available in your employer’s 401(k) program. There are income caps on Roths - AGI phaseouts begin at $101k for singles and at $159k for married-filing-jointly. So check to see whether you’re eligible.

Since the Roth is post-tax, putting $5k in a Roth is equivalent to putting $5k/(1-t), where t is your marginal tax rate. If your tax rate is 30%, then $5k in a Roth is equivalent to $5k/0.7= $7100 in a 401(k).

So, let’s say you’re a single guy earning $95k who wants to put $10k into a retirement account. His employer matches 50% of the first 6% of a 401(k) contribution.

First: let’s take the match.

Putting 6% of $95k, which is $5700, into the 401(k) maxes the match.

Second: Go for the Roth

He is eligible to contribute to a Roth, assuming that other income (e.g. interest) doesn’t put his AGI over $101k. After contributing $5700 to the Roth, he has $4300 remaining of his original $10k budget. His federal tax rate is 28%, so let’s round up to 30% to include state tax. He could put $4300* 0.7 = $3010 into a Roth, leaving $4300 * 0.3 = $1290 to go to taxes.

Traditional IRAs are taxed when the money comes out - just like 401(k)s, so they don’t offer the same kind of tax rate hedge that Roth IRAs do. However, there are no income limits on contributions to a traditional IRA, and they do let you keep more control over how the money is invested.

So if our mythical man instead earned $150k/year, making him ineligible for a Roth, he could put 6% of $150k = $9000 into his 401(k) and $1000 into a traditional IRA.

If you want to go hog wild and max out your retirement contributions, you can do the following: Max out the 401(k) match, contribute the max to an IRA (Roth or traditional), and then come back and max out the 401(k) contribution (presently $15,500).

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