Financial planners advise that you should aim to contribute at least 15% of your pre-tax income to saving for retirement but deciding exactly what kinds of accounts to put your money in, and when, can be daunting. Luckily, there's a rule of thumb for optimizing two kinds of accounts—a 401(k) and Roth IRA or Roth 401(k)—that works for most people. — Worldculturepost
Key Takeaways
- Contributing as much as you can and at least 15% of your pre-tax income is suggested by financial planners.
- The rule of thumb for retirement savings says you should first match your employer's contribution for your 401(k), then max out a Roth 401(k) or Roth IRA. Then you can return to your 401(k).
- This strategy ensures that you get the free money from your employer first, then start as early as possible to grow savings tax free in a Roth IRA or Roth 401(k).
What Is the Rule of Thumb for Investing Retirement Savings?
Add as much you can from your paycheck to max out the match if your employer provides a 401(k) match. This may take some time but focus next on Roth IRA additions after you've achieved that goal and you're matching your employer's match consistently. Then return to your 401(k) and deduct more from your paycheck if you max out your Roth IRA. Keep going until you've reached the annual limit for employee additions.
How To Use This Retirement Savings Rule of Thumb
This rule of thumb ensures that you'll benefit from company matching upfront, then it lets you make extra retirement additions where you get the best tax advantages. Following a specific set of steps for a long-term plan keeps you on course and eliminates the need to redo your plan every year.
Get Your 401(k) Match
The 401(k) is a retirement account sponsored by employers to which employees can add pre-tax income. As the account grows, returns on investments are tax deferred until the money is taken out.1 Many employers will match at least some part of their employees' 401(k) savings, which means you'll get free money for your retirement.
Some companies pay a part of employees' pre-tax additions up to a certain amount, which is often a percentage of their income. All you have to do to get the match is make the additions.
Let's say that your employer offers to match 50% of your additions, up to 3% of your annual income. That means that your employer will put in an extra 3% ($3,000), bringing your total retirement savings to $9,000 a year if you earn $100,000 a year and add 6% ($6,000) of it to your 401(k).
Your employer's matching additions are only yours if you work with the company for a certain period of time. You'll lose some or all of the matched additions if you leave before your 401(k) is vested. Your own additions are always yours.
Consult with your human resources department or look over a copy of your employee handbook to learn about your company's 401(k) matching program. With this information, you can figure out the amount you need to add to get the full match.
Add to Your Roth IRA
After you've received the full company match on your 401(k) additions for the year, focus on maxing out annual Roth IRA additions if you're eligible. Because of the absence of income limitations, you should add to the Roth 401(k) before trying to add to the Roth IRA account if a Roth option is available in the 401(k).
A Roth IRA lets you make post-tax additions, but you won't pay taxes on returns, including dividends, capital gains, and interest earned. The sooner you put your money into the Roth, the longer it will have to compound tax free. You can save up to $6,000 in a Roth IRA in 2022, or $7,000 if you're age 50 or older by the end of the year. This increases to $6,500 (or $7,500 if you're age 50 or older) in 2022. Add the maximum every year if you can afford it.
The Roth IRA also offers flexibility to avoid extra taxes on certain distributions before retirement. You can take out money to buy your first home (with limitations) or for certain medical expenses without paying the usual 10% tax on early distributions. These exceptions make the Roth IRA a vehicle that you could use for a down payment or for an emergency if you didn't have other savings.
The Roth IRA doesn't let you take an upfront tax deduction like a traditional IRA, but you can take out from it tax free when you retire.
Resume Your 401(k)
You can add a maximum of $20,500 to your 401(k) in 2022, increasing to $22,500 in 2023. Employees who are over age 50 can make an extra $6,500 catch-up addition.6 Return to your 401(k) and add any extra amount you can this year after you've added enough 401(k) contributions to match the company match, and you've reached the annual Roth IRA addition limit.
You won't receive an extra company match on these extra additions, but you'll still make pre-tax additions to your retirement savings.
Why This Rule of Thumb Usually Works
This rule of thumb works for most people because it first prioritizes maxing out the employer match to make sure you don't lose out on free money. Then it urges you to put your money into the Roth IRA so the money has the most amount of time to grow tax free. Finally, you can store more funds in your 401(k) and get more tax advantages, up to the annual limit, if you can afford to make extra retirement additions.
It's a simple plan that takes the uncertainty out of retirement savings.
A Grain of Salt: Roth IRA Addition Limits
Not everyone can afford the money needed to fully max out two or more retirement accounts, so you might not accomplish all the steps of this plan. You'll still want to follow the sequence of the priorities laid out in the rule if that's the case for you, but you might not be able to max out your 401(k) in Step 3 above.
Another thing to remember is that the Roth IRA addition limits are lower for high earners. Single filers and heads of households can make the full addition if their modified adjusted gross income (MAGI) is below $129,000 in 2022. A reduced addition is allowed if you earn between $129,000 and below $144,000. You can't add to a Roth IRA if your MAGI is equal to or above $144,000.
These thresholds are also adjusted for inflation, and they increase in 2023. Single and head of household filers can make the full addition on incomes of less than $138,000. They can make a reduced addition on incomes from $138,000 to $153,000 and they can't add if they earn $153,000 or more.
These limits increase if you're married and filing a joint return with your spouse. The 2022 limit for adding the full amount is $204,000 in this case, increasing to $218,000 in 2023. Partial additions are allowed on incomes of $204,000 to $214,000 in 2022, increasing to $218,000 to $228,000 in 2023. You can't add if your joint income is $214,000 or more in 2022, or $228,000 or more in 2023.
Even though there are limitations based on level of income when adding to a Roth IRA, you can still add to a Roth 401(k) if the option is available in the 401(k) offered. The level of income would not be an obstacle to saving in an after-tax account.
Frequently Asked Questions (FAQs)
How much should I add to my 401(k) before I add to a Roth account?
This will mostly depend on your employee benefits package. It's in your best interest to add the full amount that your employer will match to benefit from the free money if you have a 401(k) with an employer match. Talk to your HR department for details of your specific plan offerings.
Can I max out my 401(k) and my Roth IRA in the same year?
Yes, you can add the maximum to these accounts in the same year, given any income-based limitations set by the Internal Revenue Service (IRS). Keep in mind, however, that there's an overall limit for IRA additions. Your combined additions to these accounts cannot go beyond the yearly limit if you have both a Roth and a traditional IRA. Defined contribution plans like 401(k)s don't fall under this umbrella.