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Your 401(k) is the first place Dave recommends you invest for retirement once you reach Baby Step 4. And there are plenty of reasons why:
- If your employer matches your contributions—and many do—you get an instant return on your investment.
- Tax-deferred growth means your money grows faster.
- Pre-tax contributions lower your taxable income and increase the amount you can invest.
Your 401(k)’s Shortcomings
As awesome as that is, 401(k)s do have some shortcomings. First is a limited choice of mutual funds, which can keep you from investing in the best funds on the market. Second is the 401(k)’s tax-deferral. While it works to your advantage while you’re saving, it means you will owe taxes on the money you withdraw from your 401(k) in retirement.
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A Roth IRA is the perfect choice to accompany to your 401(k) because its features overcome these shortcomings:
1. Flexibility – You can choose from thousands of mutual funds to invest in through your Roth IRA. That means you can choose the best funds and diversify with different fund families.
2. Tax-free growth and withdrawals – When you retire, you’ll be able to use the money in your Roth IRA tax free. A tax-free option will come in handy since most people expect tax rates to be higher in the future.
Getting Them to Work Together
To adequately fund your retirement, you need to invest 15% of your income. For the average income of $50,000, that’s $7,500 per year. If your employer matches contributions up to 4% of you pay, for example, then you’d contribute $2,000 a year to your 401(k). The remaining $5,500 will go into your Roth IRA.
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Some things to remember:
- For 2015 and 2016, Roth IRA contribution limits are set at $5,500. If you reach your Roth IRA limit but still haven’t invested your full 15%, invest the remaining amount in your 401(k).
- If you don’t have a 401(k) or other retirement savings plan through your employer, or if your employer doesn’t match your contributions, start with the Roth IRA. If you max it out and still have money to invest, invest through your 401(k), if you have one, or open a taxable brokerage account.
Get the Most Out of Your 401(k) and Roth IRA
To get started, ask your employer how to set up your 401(k). For your Roth IRA, it’s best to work with an investing professional who can also help you choose the right funds—and even coordinate choices within both accounts.
Don't know where to start? Talk with an investing professional in your area!