Should I get a 401(k)? A Roth IRA? Or both?
As with most questions in the financial-planning realm, there’s no cut-and-dried answer. It all depends on your individual situation.
So let’s take a look at some of the things you should consider to help you decide which account is best for you.
Benefits of a Roth IRA
Roth IRA contributions are made with post-tax dollars, meaning that you’ve already paid taxes on the money contributed. This differs from a traditional IRA, where contributions can be made on a pre-tax basis for those whose income and situation qualify.
The main advantage of a Roth is that the money can be withdrawn tax free in retirement. Another advantage is that there are no required minimum distributions from a Roth at age 70½, as with a traditional IRA. This is a great estate-planning tool if your desire is to let the account grow and pass some or all of it on to children, grandchildren or other heirs. Certain holding and age requirements need to be met for the distribution to be considered qualified and therefore tax-free.
Roth IRA Eligibility
The ability to contribute to a Roth IRA is determined by your modified adjusted gross income. For 2018 the limits are:
|Filing Status||Income Level Where Phaseout Begins||Phaseout Range||Income at or Above Which Contributions Are Not Allowed|
|Married, Filing Jointly||$189,000||$189,000–$198,999||$199,000|
Modified adjusted gross income is calculated by taking the adjusted gross income from your tax return and adding back certain deductions such as student loan interest and one-half of the self-employment tax.
“Phaseouts” mean that the amount that can be contributed to a Roth IRA is reduced on a pro-rata basis within the phaseout range. Someone whose income falls at the midpoint of the range, for example, would be able to contribute only one-half of the full contribution amount. They could still contribute the difference to a traditional IRA either on a post- or pre-tax basis depending upon their situation.
For those who are eligible, the 2018 contribution limits for Roth IRAs (and all types of IRAs combined) is $5,500, with an additional $1,000 for those who are 50 or over at any point during 2018.
For those who don’t qualify to make a Roth IRA contribution, or even if you do and want to contribute more money to a Roth account, a Roth 401(k) can be a good option if your employer’s plan offers this. The contribution limits for a Roth 401(k) are higher than for an IRA: $18,500, and $24,500 for those 50 or over.
Two Ways to Fund a Roth IRA
The backdoor Roth and Roth conversions are two other ways to fund a Roth IRA.
The backdoor Roth entails contributing to an after-tax traditional IRA and then converting the money to a Roth IRA. This is a great strategy if you don’t have any other traditional IRA accounts or if the amount in the other account is small. If this is the case, the conversion can be done with little or no tax impact. If you have significant amounts in traditional IRA accounts, the benefits of the backdoor Roth strategy may be mitigated by the higher taxes you will incur on the conversion.
A Roth conversion entails converting money in a traditional IRA account to a Roth IRA. Taxes are due on all money converted except any amount already taxed in the year converted.
An employer-sponsored retirement plan such as a 401(k) can be a great option. Contributions are made via a salary reduction, meaning that they are automatic. Nothing to think about, no check to write.
The better plans often offer investment options that you may not be able to access on your own. For example, a low-cost institutional-quality investment. Plan sponsors often use advisors to help them screen and monitor the investments offered.
On the other hand, there are far too many awful 401(k) plans out there as well. By awful I mean a plan filled with high-cost, low-performing investment choices. (If you’re concerned this may be your situation, check out Blooom, a service that provides diagnostics on the health of your 401(k).)
Regardless of the quality of your employer’s plan, you will want to contribute at least enough to earn the full employer match if one is offered. For example, if your company matches 50% of the first 6% of salary that you contribute, you will want to be sure that you contribute at least 6% of salary.
The match is free money and gives you a 50% return on your money right off the bat. This type of return is hard to find, as I’m sure you will agree.
Factors to Consider
There are a number of factors to consider, including:
- Your current tax bracket and your anticipated tax bracket in retirement.
- The quality of your employer’s 401(k) plan.
- Whether or not your income precludes a Roth IRA contribution.
- The time value of money. Is it better to pay taxes now in exchange for the opportunity to withdraw the money tax free at some point in the future? Or is it better to contribute on a pre-tax basis, let the money grow tax free and pay taxes at some future date?
Why Not Do Both?
Perhaps the best answer is to do both. In fact, some combination of pre- and post-tax retirement money can be a good way to diversify your retirement savings. Nobody knows what will happen to tax rates in the future, but we do know that many of the reductions from the tax reform legislation passed at the end of 2017 are set to expire after 2025. If deficits increase, as many predict, tax hikes could be in the offing at that time.