Roth/Traditional IRA & 401(k) Playbook

Short and sweet guide on which to max first.

Roth and Traditional IRA Differences

Roth IRA

  • Contribute up to $5,500 after tax pay (your take home pay) per year
  • You may withdraw up to the amount you contribute with no early withdrawal penalty – this can double as an emergency fund, but any funds withdrawn may not be replaced
  • Tax-free growth. Tax-free withdrawals in retirement
  • Choose your own broker, such as Vanguard

Traditional IRA

401(k)

Key Points

First, some key points.

The Playbook

  1. Always contribute enough to your 401(k) to get the company match.
  2. Determine if your company’s 401(k) has quality, low-cost funds available to choose from. Look for their “expense ratios” and be sure they are well under 1%. Some companies like Vanguard, Fidelity, and more and more each day offer funds as cheap as 0.04% – 0.2%.
    1. If your company does have quality fund offerings, just contribute as much as possible to your 401(k).
    2. The maximum you can contribute (unless doing a Mega Backdoor Roth or after tax contribution, which some 401(k)s don’t support) is $18,000 per year. So, divide $18,000 by the number of paychecks you get in a year to see how much to contribute each paycheck in dollar terms. If paid twice a month, that is 24 paychecks and $750 per paycheck. If you earn $2500 before taxes/insurance/etc. per paycheck, divide $750/2500 = 30%. Set your 401(k) contribution to 30% of your paycheck.
      1. Your paycheck will actually go down less than $750. It may only go down $550 or $600; depends on what tax bracket you are in. That tax saving is going to increase how much money you are contributing that would otherwise go to the tax man.
      2. Put another way, if you are in the 20% tax bracket and you max out $18,000 per year, instead of paying $3,600 of tax for the year ($18,000 * 20% = $3,600), that money will be going to your retirement. Don’t leave this on the table!
      3. If you can swing, try to contribute more heavily at the beginning of the year and then adjust your contributions later in the year to still hit the $18,000 for the full year and still not miss any match – some companies won’t “make whole” your matches if you max your account early – you may need to be sure to always contribute no less than the matching amount on every paycheck. So that could look like you contribute 40% for the first half of the year, then drop down to 5% for the 2nd half of the year. Historically, this maximizes your returns.
  3. If you have maxed your 401(k) or you found that the funds offered by it are junk, you should then determine if you qualify for the full tax deduction for contributing to a Traditional IRA. If you do qualify for the Traditional IRA tax deduction, max your Traditional IRA. If possible, max this as early in the year as you can. Historically, this maximizes your returns.
  4. If you do not qualify for the Traditional IRA tax deduction, check if you qualify to contribute to a Roth IRA. If so, max your Roth IRA as early in the year as you can. Historically, this maximizes your returns.
  5. If you do not qualify for the Traditional IRA tax deduction and earn too much money to contribute to a Roth IRA, you may want to instead consider opening a normal investment account at a low-cost broker like Interactive Brokers (lowest cost if you have over $100,000) or Vanguard (lowest cost for the rest).
    1. If you almost have enough money to retire, this is also the point where you would consider paying off your house.

This all assumes you already have an emergency fund. If you do not have an emergency fund, you could max a Roth IRA for a couple years so you have funds available to withdraw for an emergency. Hopefully, you don’t have an emergency, and that money will just grow. If you need an emergency fund and want to save for retirement, that suggests you are strapped for cash. Here is the cheapest way to open a Roth IRA.

Other Notes

If you are going to be saving 30%, 50%, 70% of your current income in order to retire early, that also means you are used to living on 70%, 50%, or even just 30% of your current pay. This means that when you retire, you will very likely be living off of only 70%, 50%, or just 30% of your pay. This is why I say you will almost certainly be in a lower tax bracket when you retire. The concept of needing to try to decide between a Roth or Traditional IRA based on your future taxes is a false dilemma:

  1. You have no idea what future taxes will be. They may be lower, higher, or the burden may be shifted to different demographics.
  2. Mitigate your tax risk by taking all deductions you can today. People focus on company match and seem to ignore Uncle Sam taking 20% of their paycheck. Every $1000 you save in your 401(k) or deductible IRA is $150-300 that Uncle Sam doesn’t get. That’s quite a match!
  3. You do know that you will probably be living on less money than you earn today if you choose to retire when your retirement accounts can safely fund your current cost of living. So, if taxes remain similar, you will be in a lower bracket while retired.

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