A Reader Asks # 4
From the mailbag…
Art,
I have been contributing to my 401k (with 5% matching) traditionally (before tax). My rationale is that because I am only 22, compound interest will have a greater effect on the money than someone who is older. I will at the end of the year take my tax return and invest it into a Roth IRA. This way I am getting the benefit of both. I also realize the income limitations when contributing traditionally, so I might as well invest before tax as long as I can. Is my reasoning incorrect?
Figuring out how to allocate contributions between an employer sponsored plan like a 401(k) and a Roth IRA is a very common concern. In general, I recommend three stages of saving for retirement:
- Contribute to your 401(k) up to the point where you maximize your employers match
- Contribute to the Roth IRA up to your maximum limit
- Everything else
As a young professional, let's assume you make $40,000 and your employer matches 50% of your contribution up to 6% of your base salary. For step 1 I would suggest you contribute the full 6% of your salary ($2,400 per year). Then your employer would contribute $1,200 per year too. When you are 67 years old (your current social security normal retirement age) even if your salary never increased you would have over $1,500,000 at 8% returns! You are absolutely correct; compound interest will have a greater effect on your money than someone who is older.
You also qualify for a Roth IRA (Adjusted Gross Income, AGI, phase outs for 2007 start at $99,000 for a single taxpayer and $156,000 for a married taxpayer) so you can contribute another $4000 ($5,000 if you were over 50 years old) there too. If you can, that is fantastic. At the same 8% return you would have more than $1.75 million tax free available at retirement. Keep in mind that $4,000 is another 10% of your income and that the Roth IRA contributions are NOT tax deductible.
Most people in your age group would find maximizing both their 401(k) match and their Roth IRA to be a lot. Rarely would you look to continuing on to Step 3 but you could contribute more to your 401(k) (2007's legal limit is $15,500 for ages 49 and under or $20,500 for ages 50 and over) or even look to other options.
The only error I see in your thinking is that traditional contributions (that is, after tax contributions) are capped but never phase out to zero in an employer sponsored plan. It is the Roth IRA where you could lose your ability to contribute as your income grows.
Suggested Reading:
- Start saving for your retirement now @ Penny Saved
- 401(k) or IRA? Where Should You Put Your Money? @ Smart Money Daily
- Questions and Answers about Roth IRA's @ Get Rich Slowly
Do you have a question you would like to ask? If so, just email me. I will answer it here on the blog but will remove any personally identifiable information. Or, if you would rather I not post the answer, just let me know and I would be happy to keep your question and my response confidential.
Photo on flickr by chona kasinger
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