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Ask Dave

Why Split Between 401k and Roth IRA?

If Bill's 401K matches, he should save for retirement in that plan up to the percentage that his employer matches. Then put the remaining 15% of his income into a Roth IRA or max it out.

QUESTION: Bill asks why he should split 15% of his income between 401Ks and Roth IRAs. Why not just use the 401K?

ANSWER: Let’s say you’re 30 years old bringing home $40,000 a year.  If you put 15% of that into retirement, that’s $6,000 a year - $500 a month.  If you put $500 a month into good growth stock mutual funds that average 12% from 30-70 years old, then you would have almost $6 million.  Over 40 years, you’ve put in $240,000 and your return is $6 million.

If you do that in a 401K, that money is taxable.  The money went in before taxes, but the money is taxable as it comes out.  Your $240,000 that went in pre-tax is almost irrelevant in light of the $6 million that is going to be taxed.

But if you put money in a Roth IRA, it grows tax-free.  That means if you put the same amount into the Roth, you’ve got $6 million, none of which goes to Uncle Sam.  The Roth IRA is always superior to the 401K because of this.

If your 401K matches, you should save for retirement in that plan up to the percentage that your employer matches.  Then put the remaining 15% of your income into your Roth IRA or max it out – whichever comes first.  If you haven’t reached your 15% amount by the time you’ve maxed out the 401K match and the Roth IRA, go back to the 401K unmatched because at least it’s growing tax-deferred. 

After you get through Baby Step 6, go back and max out all retirement savings plans if they are not already maxed.

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