While I like to answer readers’ questions to the best of my knowledge, please keep in mind that I am not a financial professional. If you have questions, feel free to contact me. Any questions for which I can’t provide a detailed answer, I often just open the conversation up for discussion, as I know that many of the readers here are intelligent and experienced in this field — more than I am.
This question comes from Lindsey:
Hello! I’m 23 years old and I have just started a 401(k) with my employer. Should I also have a Roth IRA? What do you recommend? I’m a little confused. Thanks!
First of all, congratulations for starting your 401(k)! When I first entered the workforce, I didn’t have that option. In fact, I didn’t even have an option for a 403(b) — a similar plan, but for non-profits — until I was about 25 or 26. Unfortunately the organization wasn’t paying me enough to even afford to commute there, and I didn’t trust the individual who came to our company to “sell” us the plan.
Here’s what I would do in your position, and I think this is the generally accepted financial advice.
You didn’t provide any information on salary, so I would assume that you are making less than $99,000, which is the point that Roth IRA benefits will begin phasing out for you. With that in mind, I suggest funding your 401(k) up to the point you get the maximum benefit from your employer. Many companies offer employer matching. One example would be a 50% match of your first 6% contribution. To make the most of this benefit, you would need to contribute 6% of your salary.
Once your 401(k) is funded to that amount, I’d go ahead and put whatever you can into a Roth IRA account. The Roth IRA is funded after tax, which helps diversify your tax exposure. (The 401(k) is generally funded pre-tax, which means your contributions are deducted directly from your gross income.) The maximum you can invest in your Roth IRA is $4,000 this year, and you can spread that out throughout the rest of the year.
If you have any money left over for investment, you can put more into the 401(k) if you company offers you low-cost options. Otherwise, I’d think about your savings goals (car, house, family, etc.) and deposit that cash in funds whose risk and return matches your tolerance and time horizon for those goals.
You didn’t ask about this, but I think it’s important to mention: You should probably build up a cash reserve for emergencies so you don’t have to tap your credit cards if you suddenly lose your job or have hospital bills. Another aspect to consider is whether you have debt to pay off, such as student loans or credit cards. These are all points to consider when working out your overall financial plan, but I won’t expand on these ideas as your question focused only on the 401(k) and Roth IRA.
Published or updated June 15, 2007.
{ 10 comments… read them below or add one }
I’m not a finacial professional either but I 100% agree with Flexo. A Roth IRA is an excellent way to save for retirement.
Wehne comparing vs a traditional ROTH, here is a simple checklist to see which you should choose. If both of the following are true, take the Tradtional IRA over a ROTH
1) I plan to have quite a bit less taxable income when I retire than I do now.
2) I think income tax rates will remain the same or lower when I retire.
But, in general, the ROTH is nearly always the best option.
Bnrl: that’s a good rule of thumb, but for a 23 year-old who may retire 40 years from now, one can only take a wild guess as far as tax rates.
I like the flexibility and diversity of having both, especially because it’s so hard to know what my income/tax level will be when I retire. I feel like I have more control over my ROTH than my 401(K) because it’s not tied to my job. I do what you suggested and I put 6% (of my pre-tax income) into the 401(K) to get the max matching, and the rest (9%) into the ROTH.
What is the recommendation for those who are fortunate enough to be ineligible for Roth contributions?
ntguru (comment #5),
I’m in the same boat as you are. I am stuffing my traditional IRA and waiting for 2010. link
Use any extra money (e.g. tax deduction from contributing to traditional IRA) for other investments (stock market in my case).
This is the best post I’ve read about this subject. I have a 403b and a Roth… but no match! So, I max out Roth first and then put as much as I can in 403b…
NCN
totally agree with the advice mentioned in the post. The one thing I would add is that with the Roth IRA (or traditional) you can invest in a number of different things – stocks, mutual funds, etc, as opposed to the 401k where you have limited options.
With the Roth you also have the ability to withdraw your deposits without penalty or taxes in case of an emergency (although I’d recommend against this).
The other alternative is the Roth 401(k), which many companies will be instituting in the next year. It allows people to put money into a Roth account without hitting the income limits.
Lost Opportunities (comment #9),
If you are ineligible for Roth ased on limits, would you also not be eligible contributing to Traditional IRA. Am i missing something ?