We talk to people every day who are trying to build a strong financial future. And one of the best pieces of advice we can give is this: Your workplace 401(k) is the foundation of a solid retirement plan,
Is that the most exciting investing tip out there? Not really. But do you know what is exciting? Becoming a millionaire! According to our National Study of Millionaires, eight out of 10 millionaires said their 401(k) was their main wealth-building tool. There’s a reason for that!
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). That’s free money. Take it!
- 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 $19,500 per year (and your spouse can also invest that amount). If you’re 50 or older, the contribution limit increases to $26,000 per year to help you catch up.1
But hold up: 401(k)s do have some shortcomings. First, you’ve got a limited number of mutual funds to choose from, which can keep you from investing in high-performing funds on the market. Second, your 401(k)’s tax-deferred growth is a double-edged sword. While it works to your advantage while you’re saving today, it means you’ll owe taxes on the money you withdraw from your 401(k) in retirement tomorrow—unless your employer offers a Roth 401(k), which we’ll get to in a minute.
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That’s why you usually need more than just a traditional 401(k) if you want a secure retirement. So, what else should you invest in?
The Advantages of a Roth IRA
Almost three-quarters (74%) of the millionaires we talked to also said they invested outside of their workplace retirement plan. It’s not either/or—it’s both! And when it comes to investing beyond your 401(k), the best tool you can use is a Roth IRA.
Here’s why a Roth IRA is the perfect choice to accompany your 401(k):
- Tax-free growth and withdrawals. When you retire, you’ll be able to use the money in your Roth IRA tax-free. Did you hear that? 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!
How badly can taxes reduce the lifespan of your retirement account? Let’s 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 12% tax bracket (most Roth IRA withdrawals in retirement do not count toward your taxable income). And, just to keep things simple, we’ll also assume no additional growth after you retire.
You’d actually have to withdraw $28,200 from your 401(k) to cover your taxes and still get the income you need. After seven years, you’d only have $2,600 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 key player in your retirement plan.
How the Flexibility of a Roth IRA Works in Your Favor
While your 401(k) plan might not have a lot of mutual funds to pick from, you can choose any of the thousands of existing mutual funds for your Roth IRA. How do you know which funds are right for your portfolio? 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 sound like boring investment lingo, but aside from increasing the amount you invest for retirement, spreading out your investments by selecting a balanced mix of mutual funds is probably the best thing you can do with your retirement savings. 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.
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, we recommend investing 15% of your gross income. That means if you make $50,000 per year, you should be investing $7,500 into retirement savings.
How do you divide that between your 401(k) and Roth IRA? 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. Boom. You’re done!
- What if my employer 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 my employer doesn’t offer a retirement plan at all? Go max out your Roth IRA first. And then, if you still haven’t hit 15%, you can open up a taxable brokerage account to invest in growth stock mutual funds.
- What if I max out my Roth IRA and still haven’t met my 15% goal? The contribution limit for Roth IRAs is currently $6,000 per individual, and it increases to $7,000 if you’re 50 or older.2 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. When you withdraw money in retirement, you won’t have to pay taxes on your contributions or its growth—but you will have to pay taxes on the match your employer provided. 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
When it comes to your 401(k) and a Roth IRA, there’s no need to pick sides! The investments you choose for both accounts should complement each other. They should work together to help you make the most of the stock market’s growth while limiting your risk.
Don’t know where to start? Our SmartVestor program can connect you with an experienced investing professional in your area. They can help you find out if you’re on track to meet your retirement goals and what you can do to make your outlook even brighter.