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Your workplace retirement plan—a 401(k)—is the foundation of a solid retirement plan. It’s the first place you should invest for retirement once you reach Baby Step 4. Here’s why a traditional 401(k) is a great place to start your retirement savings:
- If your employer matches your contributions— and most do— you get an instant 100% return on part of the money you invest in your 401(k).
- Tax-deferred growth means your money grows faster.
- Pre-tax contributions lower your taxable income, which makes it easier to invest more.
- You can invest up to $18,000 per individual per year. If you’re 50 or older, the contribution limit increases to $24,000 per year.(1)
As great 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 high-performing 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.
That’s why you usually need more than just a traditional 401(k) if you want a secure retirement. So what comes next?
"That’s why you usually need more than just a traditional 401(k) if you want a secure retirement." —Chris Hogan
The Advantages of a Roth IRA
Here’s why a Roth IRA is the perfect choice to accompany your 401(k):
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- 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.
- Flexibility. You can work with an investing pro to choose from thousands of mutual funds to invest in through your Roth IRA. That means you can choose high-performing funds and diversify with different fund families.
These may seem like minor details, but they can make a big difference in the size of your nest egg over time.
How Tax-Free Withdrawals Help Your Retirement Savings
When you retire, the money you’ve saved in your Roth IRA will stretch further than your 401(k) savings for one big reason—taxes!
Here’s an example of how taxes can limit the life-span of your retirement account. Say your 401(k) and your Roth IRA both have $200,000 balances. You withdraw $25,000 from each for a $50,000 annual income in retirement. Let’s assume your income puts you in the 25% tax bracket, and for ease of calculation, we’ll also assume no additional growth after you retire.
You’d actually have to withdraw $31,250 from your 401(k) to cover your taxes and still get the income you need. After year six, you’d only have $12,500 left in your 401(k). Your Roth IRA, on the other hand, would hold out until the end of year eight.
This is a simple calculation, but it makes the point: Taxes will impact how long your nest egg will last. That makes a tax-free Roth IRA a must for a secure retirement.
"Taxes will impact how long your nest egg will last." —Chris Hogan
How Flexibility Works in Your Favor
While your 401(k) plan may offer a limited selection of mutual funds, you can choose any of the thousands of existing mutual funds for your Roth IRA. Work with an investing pro you trust to help you weigh the pros and cons of different fund options.
With thousands of funds to choose from, you can select good growth stock mutual funds to build what the investing experts call a “well-diversified portfolio” to grow your retirement nest egg.
That might not sound like a big deal, but investing studies have shown that aside from increasing the amount you invest for retirement, selecting a balanced mix of mutual funds has the largest impact on how much your retirement account will grow—up to 20% in a study by The ASPPA Journal.(2) A Roth IRA gives you the freedom to choose a balanced mix of mutual funds for retirement: 25% growth, 25% aggressive growth, 25% growth and income, and 25% international.
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How Do Your 401(k) and Roth IRA Work Together?
When you invest in your workplace 401(k) and a Roth IRA, you’re able to harness the power of the match in your workplace 401(k) with the tax-free withdrawals and flexible fund options of a Roth IRA. It’s a winning combo!
Investing in two retirement accounts isn’t complicated. You just have to do some quick math. To adequately fund your retirement, I recommend investing 15% of your income. If you bring in $50,000, that’s $7,500 per year.
If your employer matches contributions up to 4% of your pay, for example, then you’d contribute $2,000 a year to your 401(k). The remaining $5,500 would go into your Roth IRA.
- What if my employer doesn’t offer a retirement plan or doesn’t match contributions? Max out your Roth IRA first. If you still have money to invest, you can invest in your company plan if available or open a taxable brokerage account.
- What if I max out my Roth IRA and still haven’t met my 15% goal? The contribution limit for Roth IRAs is currently $5,500 per individual, and it increases to $6,500 if you’re 50 or older.(3) It’s possible that you might not reach 15% of your income in your Roth IRA. If that happens, go back to your 401(k) and invest the remainder to take advantage of your 401(k)’s tax deferral.
- What if my employer offers a Roth 401(k) option? Great! A Roth 401(k) works almost exactly like a Roth IRA. It’s funded with after-tax dollars and grows tax free. You won’t have to pay taxes on the money you put in or its growth when you withdraw it in retirement, although the match that your employer provides will be taxed. If you have good mutual funds to choose from, you can invest your entire 15% in your Roth 401(k).
Get Team 401(k) and Team Roth IRA on the Same Side
The investments you choose for your workplace 401(k) and your Roth IRA account should complement each other. They should work together to help you make the most of the stock market’s growth while limiting your risk.
An experienced investing professional can show you how to accomplish this goal and answer any questions you have about your investment accounts. By showing your pro your entire retirement picture, you can find out if you’re on track to meet your retirement goals and what you can do to make your outlook even brighter.
Don’t know where to start? Try this free and easy way to find an investing professional in your area!
About Chris Hogan
Chris Hogan is the #1 national best-selling author of Retire Inspired: It’s Not an Age. It’s a Financial Number and host of the Retire Inspired Podcast. A popular and dynamic speaker on the topics of personal finance, retirement and leadership, Hogan helps people across the country develop successful strategies to manage their money in both their personal lives and businesses. You can follow Hogan on Twitter and Instagram at @ChrisHogan360 and online at chrishogan360.com or facebook.com/chrishogan360.