Why maxing out 401k first, then maxing out Roth IRA?

[goals^n^dreams]

I have heard that people contribute max out 401k (company matching), then they max out Roth IRA (5.5k). Why they dont put the 5.5k from Roth IRA in 401k? I really dont see any benefit between 401k and Roth IRA even though I currently have both. Am I missing something about 401k and Roth IRA?

My info:
I have contributed after tax for 401k and Roth IRA. I have JH Retirement Fund 2050 Managed Port for 401k, and Target Retirement Fund 2050 at Vanguard for my Rorth IRA.

I still dont see any benefit or difference between 401k and Roth IRA.

 

[niehlin2]

Roth IRA is not subject to required minimum distribution until after the death of the owner. This will help.

 

[Matt]

A 401k can be either a Roth or a Traditional, its most commonly a traditional. So when they talk about both we have:

• Traditional=Tax Deferred
• Roth=Tax Free

• The tax deferred means 'until you change that' (important distinction from what many people think 'in retirement') so you don't pay tax on it now, you pay tax on it later, whenever you want, until you hit age 70 1/2 per @niehlin2 point about RMDs (forced to withdraw).
• Tax Free means in retirement (or from 59 1/2) you pull out the funds, including any asset growth tax free. The price for this is you pay taxes on the money today (it is an after tax contribution).

As to the order of things, its a tricky topic. It is easy to say that the matched 401k is superior as the company money is a free bonus - after that some people think contributing to a roth is a good idea. Personally, I try to pay an effective rate of between zero and 3% tax so I'm a big fan of traditonal IRAs when I'm earning money, and slipping it into Roths when I'm not.

 

[Sesq]

Your IRA can be at an institution with virtually unlimited investment options. Your 401(k) [and often 403(b)] may have limited options and lousy fee structures, especially small plans where the company sponsor will let the provider charge high fees to avoid paying for admin costs out of the business. If you work for a very large employer the opposite may be true as you may find that your plan has "Admiral" (or whatever, institutional class) shares available regardless of the individual account balance. In that instance your index fund may have an expense ration of 3 basis points versus 20 basis point that you may find in your IRA offer. A bad 401(k) may have funds with ER of 200 basis points (2% per year). Worth sucking up it you are getting a dollar for dollar match, or even 25 cents on the dollar.

Other considerations are a 401(k) has superior asset protection laws if *you* go bankrupt. There are however instances where the protection is inferior if the employer goes bankrupt. Usually that risk is on the more recent contributions that haven't made their way into the plan. But outright fraud can happen, usually with greater risks for smaller employers. I don't recall the details, but certain flavors of 457 plans have additional sponsor bankruptcy risks.

Folks also favor the Roth IRA as a tax diversifier, so sometimes the advice is meant to capture the suggestion that it is good to have some in both Roth and Traditional flavors. Also, the RMD point (easily cured with a rollover at age 70).

I work for a mega employer with access to low expense ratio funds. For a while when I couldn't max everything I skipped the IRA contributions for a few years and only did the 401(k). I favor Roth for my 401(k) and IRA, although at my tax rate that is probably not the best choice. I think my true marginal tax rate (inclusive of means testing and state taxes) will be equal or comparable in retirement so I take the risk that I am overpaying today.

 

[jd13]

^^ Good info there. Investment cost, employer matching, asset protection are things to consider.

I am about 25% roth / 75% traditional between 401k and IRAs. You have to do your own analysis there depending on your current and projected income.

One possible benefit of contributing to the IRA first is that tax deductible IRA contributions are phased out beginning at modified AGI of $61k (for 2015 if covered by employer retirement plan). So if you don't make more than that, it may benefit you to contribute to the IRA if no employer 401k matching, or even if there is.

 

[DanR]

A 401k can be either a Roth or a Traditional, its most commonly a traditional. So when they talk about both we have:

• Traditional=Tax Deferred
• Roth=Tax Free

• The tax deferred means 'until you change that' (important distinction from what many people think 'in retirement') so you don't pay tax on it now, you pay tax on it later, whenever you want, until you hit age 70 1/2 per @niehlin2 point about RMDs (forced to withdraw).
• Tax Free means in retirement (or from 59 1/2) you pull out the funds, including any asset growth tax free. The price for this is you pay taxes on the money today (it is an after tax contribution).

As to the order of things, its a tricky topic. It is easy to say that the matched 401k is superior as the company money is a free bonus - after that some people think contributing to a roth is a good idea. Personally, I try to pay an effective rate of between zero and 3% tax so I'm a big fan of traditonal IRAs when I'm earning money, and slipping it into Roths when I'm not.

Picking nits, here, I know, but if you're not earning money, you can't contribute to a Roth. I'm guessing you meant that you meant when not earning a lot of money you prefer a Roth

To ops question: one thing I didn't see mentioned about Roths is that you can withdraw your contributions without penalty at any point - not the same in a 401k. Whether that is a wise move or not is another question entirely

 

[Matt]

Picking nits, here, I know, but if you're not earning money, you can't contribute to a Roth. I'm guessing you meant that you meant when not earning a lot of money you prefer a Roth

You can contribute via a spouse, but yeah, I mean, when I say earning money I mean when I am up in the higher brackets rather than the lower ones... at minimum I tend to pay myself a salary of around $5K in zero years so that I can gather SSI credits.

 

[WesleyM]

This is very ironic as I was looking at Roths and actually opened one along side my existing stock acct at E Trade. Now, my question is am I making the right decisions here? I have 401K with my (very large blue and yellow themed Circuit City spin off) company that pays company match at 1/2% up to 5% (pre-tax), so effectively I am getting 2.5% income match on the 5% that I contribute and is administered by T Rowe going to the target date 2055 fund. I have a 50% cap but do not see it as worth it to go above the 5% currently, tell me if I'm wrong. I just started the Roth, and it had 0 minimum so I just rolled some free cash I had in my E-trade over. I ALSO have an employee stock purchase plan that provides a 15% match on up to 10% of my income (post-tax) and does have a 10% cap. The employer contributions do gross me up so they add to my taxable income. I am also contributing 5% to it currently, so have another 5% I could go up to the max contribution there and obtain some more company matching. So, what should I change and what should I increase in what order to get the maximum bang for my buck? I feel like I should raise my 5% stock purchase to the max 10% first of all, then attempt to max out my Roth, then anything else I want to look at for retirement income should go to an increase of 401K which will also help reduce my tax basis. Advice? My situation is a bit more complicated than the traditional articles cover as I have the additional wrinkle of company stock involved. Let me know if you need any more info either via a reply or PM and I'll give you what I've got.

 

[rajin]

Wesley,

Adding enough to the 401k to get the match is the right move almost always, so you're good there. You should asked if a Roth 401k option is available though, they are becoming more prevalent at large companies especially. That would likely be worth switching too, especially since you're young (assuming from the target 2055 fund) and will be making more money later than you are now.

Good idea moving taxable accounts into the Roth. Unless you're saving for something specific, or they are an emergency fund for you, most taxable brokerage accounts would be better off in IRA of some flavor. Roth IRAs are actually a very good home savings option in some situations, but that's off-topic.

If you can sell the funds relatively soon from the ESPP, you should. You're already heavily invested in your company by working there, diversify your investments elsewhere. With the employer contribution, you're getting an instant 15% return though, so it's a great deal.

So, take your budget, decide how much you can spare to save every month, and start putting money in this priority.
1) 401k up to 5% of salary (easy 50% return) (roth 401k if available)
2) ESPP up to 10% of salary (easy 15% return, but sell it ASAP and diversify.)
3) Roth IRA up to annual max
4) 401k up to annual max (roth 401k if available)
5) Taxable savings


That assumes you have enough of a basic emergency fund first, which it sounds like you do since you had taxable brokerage accounts already.

If you are not using all of your tax-advantaged saving space each year (items 1-4), consider moving part of your existing taxable savings into those vehicles (probably the roth IRA)

 

[WesleyM]

My stock is purchased and added to my account on a monthly basis. I could in theory sell monthly, however I do incur a fee to sell, so that would greatly reduce my profit on the 15% match. I'm not EXACTLY sure how the fee structure works and would have to check into that but I believe it is a flat fee possibly plus some sort of percentage so in theory waiting longer would reduce the % cost basis of the sale. If it is in fact a flat fee or a flat fee plus a percentage how often do you advocate selling? I actually have a target amount I am looking for in the account currently to pay off an outstanding loan but after that transaction I will be more free to play around with that account, as it is held at a brokerage sponsored by the company and isn't in the same account as all my other investments. You are correct to believe I'm younger (25), and I do somewhat have an emergency fund and easy access if necessary. Send me a PM if you'd like to not clutter up the thread and ask any more questions as I don't want TOO much information in the L1 forum and easily searchable from outside.

 

[Matt]

1) 401k up to 5% of salary (easy 50% return) (roth 401k if available)
2) ESPP up to 10% of salary (easy 15% return, but sell it ASAP and diversify.)
3) Roth IRA up to annual max
4) 401k up to annual max (roth 401k if available)
5) Taxable savings

Yep. And as @rajin mentioned watch out for being too heavily concentrated.

I don't think you can buy and then sell without tax implications, if it is a qualified plan then selling without holding correctly would result in a disqualified disposition. You should review the terms closely.

 

[Mountain Trader]

This is very ironic as I was looking at Roths and actually opened one along side my existing stock acct at E Trade. Now, my question is am I making the right decisions here?

In my experience, anyone who has opened an account at E Trade has not made the right decision.

 

[WesleyM]

In my experience, anyone who has opened an account at E Trade has not made the right decision.

They work well aside from the $10 trade cost unless someone else sees something I do not?

 

[WesleyM]

Yep. And as @rajin mentioned watch out for being too heavily concentrated.

I don't think you can buy and then sell without tax implications, if it is a qualified plan then selling without holding correctly would result in a disqualified disposition. You should review the terms closely.

I THINK I can sell as soon as I desire after my account is funded with the monthly purchase. As I said before I do get grossed up the amount of the company match so I'm paying taxs on that bi-weekly either way. I put a message in to them last night to check the fee structure for sales and also put a message in to T Rowe to see if I can convert my 401k to a roth based unit.

 

[rajin]

I THINK I can sell as soon as I desire after my account is funded with the monthly purchase. As I said before I do get grossed up the amount of the company match so I'm paying taxs on that bi-weekly either way. I put a message in to them last night to check the fee structure for sales and also put a message in to T Rowe to see if I can convert my 401k to a roth based unit.

I googled your company ESPP, and it's pretty clear that you can sell immediately, but there's a 25$ fee for each transaction. You may want to do it quarterly or semiannually. Still, pretty generous of them.

It's all on a post-tax basis, so you can just take the sales money and put it in your Roth IRA.

 

[WesleyM]

I googled your company ESPP, and it's pretty clear that you can sell immediately, but there's a 25$ fee for each transaction. You may want to do it quarterly or semiannually. Still, pretty generous of them.

It's all on a post-tax basis, so you can just take the sales money and put it in your Roth IRA.

I figured I dropped enough of a hint in my initial post to determine who it was I was referring to. Even at the 5% I have been contributing it averages $~30 a month in company match so 1 month of match would offset the sale cost and probably the tax implications. I will probably ramp it to the 10% max starting in September as I have a few other uses for the 5% this month and start cashing out quarterly. Right now if I cashed out I would be able to harvest a modest $200 capital loss but it isnt at the level to pay for the item I have in mind yet. Thanks for the advice, I'll take anything youve got to help get me out of the debt I created when I was younger and on the way to a comfortable retirement, since by the time I get to 62 Social Security will surely not exist in it's current form