Which has priority? My 401(k) or my Roth IRA?

NEW YORK (Money) -- Question: I'm 28, married and I recently started a new job. I contribute 10% to my 401(k) and my employer matches the first 4%. I also contribute to a Roth IRA. If I'm only able to fund one retirement plan, or if I wanted to think of one as being a higher priority than the other, which plan should it be? - Ryan Bergan, St. Paul, Minn.

Answer: It's nice to have choices, especially when it comes to saving and investing for retirement. It gives you more financial maneuvering room. And that, as Martha might say, is a good thing.

But unless you have a strategy for dealing with the various retirement savings options, choice can also be confusing. And in some cases, it could lead to making bad decisions or, worse yet, foregoing any decision at all. And that isn't a good thing.

So let me give you a strategy for dealing with the 401(k) vs. Roth IRA question. Let's call it my...well, let's just call it my Strategy for Dealing with the 401(k) vs. Roth IRA Question, okay?

The premise to this strategy is that 401(k)s and Roths each offer something worthwhile, but slightly different and that having both in your retirement-planning arsenal is better than having just one.

Among the many advantages 401(k)s offer is that they make saving for retirement easy. The money comes right out of your paycheck so that, other than sign up for the plan, you don't have to do a thing. You also get an immediate tax break in that the money you contribute isn't taxed until you withdraw it, preferably during retirement.

Most employers also throw in matching funds. Your company matches the first 4% of what you contribute, but it's not uncommon for employers to match up to the first 6% or more.

And, finally, 401(k)s have relatively high contribution limits. Federal law allows you to sock away up to $15,500 this year (although your plan may effectively impose a lower ceiling), plus up to an additional $5,000 if you're 50 or older.

So a 401(k) clearly should be a cornerstone of your retirement planning.

On the other hand, a Roth IRA has some nifty features too. You don't get a tax break upfront since you're investing after-tax dollars, but you do get one at the end namely, you can withdraw your contributions and earnings tax-free (provided you meet the withdrawal requirements, which you can read about by clicking here.

The Roth IRA contributions limits are lower than those in a 401(k) - $4,000 this year, plus another $1,000 if you're 50 or older but we're still talking decent bucks.

Of course, you've got to meet the eligibility requirements to contribute, although even if you don't there are other ways to get money into a Roth. One is to do a Roth conversion, again, assuming you meet the are eligibility requirements, although there are ways around those too, as I explained recently in my Long View column in MONEY Magazine.

(By the way, some employers are also offering a Roth 401(k) option in their company 401(k) plans. So if a Roth IRA option is out, you may be able to get tax-free withdrawals through a Roth 401(k).)

But as attractive as these plans are individually, they work even better as a pair. Why? Well, think about it. With a 401(k), you're avoiding tax on your contribution today, but paying tax on withdrawals in the future. That means a 401(k) works best if you think your tax rate is higher today than it will be in the future. You're avoiding taxes at a higher rate and paying them at a lower one.

The reverse is true of a Roth, where you're paying tax on your contribution today and avoiding taxes in the future. Thus, a Roth is a better deal when you expect your taxes will be higher in the future since you're paying the lower tax bill today instead of tomorrow's higher one.

The rub, of course, is that we can never be certain whether our tax rate will be higher or lower in the future. Even if you expect that your income will be lower in retirement, you may also lose lots of deductions (mortgage interest, retirement-plan contributions) that could result in a higher rate. And there's always the chance that Congress could raise tax rates, hardly a stretch given the difficulties Social Security and Medicare face.

But by putting money in both a 401(k) and a Roth IRA, you're hedging your bets. I call this strategy "tax diversification" because, like asset allocation, it prevents you from making an all-or-nothing bet (although in this case, you're protecting yourself by diversifying your exposure to tax rates instead of different types of investments).

I'd also add that having different pots of money taxed different ways gives you more flexibility in managing your income in retirement. If, for example, withdrawals from a 401(k) combined with Social Security and other income are about to push you into a higher tax bracket in a given year, you can always dip into your Roth. (For more on the advantages of tax diversification, click here.

So how can you maximize the advantages of both these savings plans? Well, that brings us to the heart of my Strategy for Dealing with the 401(k) vs. Roth IRA Question. It's quite simple, really.

You start by contributing enough to your 401(k) to get the full employer match. This will give you the biggest bang for your 401(k) bucks: the convenience of payroll deductions, the upfront tax break and your employer's matching funds, aka "free money."

Next, contribute as much as you can to a Roth IRA, up to the limit. By taking this step, you get the advantage of tax-free withdrawals down the road, plus you get the tax diversification I referred to earlier.

If you still save more money after this and I hope you can, since for many people these two steps alone won't lead to a nest egg large enough to assure a comfortable retirement then funnel your additional savings into your 401(k) until you reach the contribution limit. You won't be getting the bonus of an employer match, but you'll still get the convenience of payroll deductions, plus your money will grow without the drag of taxes until you withdraw it.

And if you are able to save still more? Well, then plow that money into taxable accounts with an eye toward options such as tax-managed funds, index funds and ETFs, all of which minimize how much of your gains go to the tax man. (For more on these options, click here.

Now, as a practical matter, you're not going to contribute to your 401(k), then do the Roth, then go back and increase your contribution to your 401(k). That would be unwieldy.

Rather, just sit down at the beginning of the year and figure out how much you can afford to save try to err on the side of socking away more and calculate how much you'll need to get the full 401(k) match. Next, add in the Roth and then see what's left over for the 401(k). You can then set your annual 401(k) contribution based on the total amount you can put into the 401(k) after allowing for the Roth. (If you later find you can save more and you aren't maxing out your 401(k), you can always go to your HR department or 401(k) administrator and up your contribution during the year.)

In any case, that's the strategy in a nutshell: do the 401(k) to the full match, then the Roth, back to the 401(k) and, if you can save still more, look for good options in taxable accounts.

If you do this on a regular basis, you should not only have a nice fat nest egg when you retire, you should also gain some decent maneuvering room for reducing the tax bite on withdrawals from that nest egg during retirement.


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