Q: I’m 32, and I save 5 percent of my salary to my 401(k) plan so I can get the full company matching funds. I can afford to save maybe another $3,000 a year. Should I do it through my 401(k) or open a Roth IRA instead?
A: Kudos on being a saver and looking for ways to increase your savings. One of the main items to consider is how you’re balancing your long- and short-term goals.
“Contributions to any retirement account should be considered long-term savings and therefore not accessible for shorter-term goals like buying a home or paying for education,” said Jim McCarthy, a certified financial planner with McCarthy Wealth Solutions in Rockaway.“Also, before committing additional savings to your retirement be sure you have an adequate emergency fund — usually three to six months of expenses — set aside.”
The next issue is your current tax bracket.
McCarthy said contributions to your 401(k) reduce your current taxable income, whereas contributions to a Roth are done with after-tax dollars.
“With the 401(k), you save taxes now, but pay taxes down the road when you access the account for retirement income,” he said. “With the Roth, there is no immediate tax savings but future distributions may be tax-free if taken after you are over 59 ½ years old and have had the Roth for at least five years.”
McCarthy said you should see if your employer offers a Roth 401(k) option, which is becoming more and more popular.
The advantages of the Roth 401(k) over a regular Roth IRA are that the Roth 401(k) doesn’t have income phase-out for contributions, which Roth IRAs do have. Also, the Roth 401(k) has higher contribution limits — $17,500 in 2014 — versus a Roth IRA, which has a maximum contribution of $5,500 in 2014.
“If you are currently in a lower tax bracket — 10 or 15 percent — the Roth contribution would probably yield better long-term results,” McCarthy said. “If you are currently in a higher tax bracket — 28 percent and up — or if the additional 401k contribution moves you into a lower tax bracket, then that is the way to go.”
In general, McCarthy said he likes splitting retirement savings between pre-tax accounts (401(k)s and traditional IRAs) and post-tax accounts (Roth 401(k)s and Roth IRAs) because that as that provides “tax diversification.”
Amanda Lott, a certified financial planner with RegentAtlantic Capital in Morristown, said based on what you’ve said, the Roth IRA may make the most sense, in part because of that “tax diversification.”
“Your 401(k) withdrawals will be taxable at ordinary income rates and your Roth IRA withdrawals will be tax-free,” she said. “Since a lot could happen with tax rates, your income levels, and eventual cash flow needs between now and your retirement, creating asset buckets with different tax natures is prudent.”
Just be sure to double-check the income requirements before you save to a Roth IRA.
Also, given that you’re covered by a retirement plan at work, assuming you’re single, as long as your modified adjusted gross income (MAGI) is less than $114,000, you can contribute up to $5,500 to a Roth IRA in 2014, Lott said.
Check this IRA link to see limits for other filing statuses.
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