Being a personal finance evangelist is like being a teacher in one way – we spend a lot of time focused on the kids who are having difficulty with the material. So much so, that the high achievers don’t always get the attention they need and deserve.
Perfect example: When it comes to the lesson of funding retirement accounts, we’re heavily focused on trying to teach most of the class to:
- Start saving early. Say it along with me, smart kids: Start saving on day one of your first job so years of compounding can work their magic on your nest egg.
- Save at least 20% of your gross income.
- Enroll in your companies 401k. The tax advantages and likely contribution match from the boss is like getting free money.
This is important but basic stuff that the best money students have already mastered. So how about we do a quick advanced lesson for those of you who have the income, discipline and desire to max out your retirement savings. What’s the best way to do that? Here is the three-step strategy I recommend:
- Fund your 401k up to the employer match. Makes sense, right? You don’t want to leave any free money on the table. Employers who offer to match your contribution will typically do so up to 3-6% of your annual salary. So, if you make $60,000 and your boss matches your 401k up to 5%, be sure to contribute $3,000 over the course of the year.
- Fund a Roth IRA to the max. Contribute $5,500 to a Roth IRA; $6,500 if you are 50-plus years old.
- Top off the 401k. Turn your flow of dollars back to the 401k and get as close as possible to the maximum $18,000 annual contribution. ($24,000 if you are 50-plus.)
Why not just put it all in the 401k? Good question, smarty. The answer has to do with future tax benefits. Your 401k contributions are deducted from your taxable income in the year you make them. But you do get taxed on that money when you withdraw it in retirement. Conversely, Roth contributions are not tax-deductible in the year you make them. However, 30 years from now when you make withdrawals from the Roth, that money will be tax-free.
So, funding both a 401k and a Roth gives you the best of both worlds. You get a tax break and employer-contribution this year from the 401k contribution. Then in retirement, when tax rates may be higher, you get tax-free distributions from the Roth. It’s free money coming and going!
Smart. Very smart.
Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.