Friday, August 05, 2005

Rule #6: Max out your 401k and Roth IRA


  • Contribute the maximum allowed amount to your 401k and Roth IRA every year.

I started this with my first job and I'm so glad I did. I decided it would hurt less if I just started out my working life without having that money in my check, as opposed to making the decision to start taking it out later. I like being forced to save money-- I am not so disciplined that I don't need this kind of help! And of course it is great that it is deducted before taxes, and my employer matches a portion of my contributions too.
The Roth IRA was a little harder, since I had to make myself set it up! There were a couple of years where I didn't get around to it, but I have 6 years' worth of maximum contributions now. The first couple were CDs at my local bank, which involved going in and talking to someone at the bank who wasn't very helpful. But now I have an E*Trade Roth IRA account, so for the last few years it's been easy to just transfer the money in, and I've been putting it into mutual funds that will hopefully earn more than CDs in the long run.
Retirement is such a tricky subject. According to the calculator in Quicken, if I continue at this pace, I should at least be able to retire in my early 70s without starving to death. But that assumes a lot of variables that I’m just not sure about: what will my tax rate be when I retire? How old will I be when I retire, and how long will I live after that? Crystal ball, anyone?

17 comments:

Brown-bag beauty blog said...

Hi there! I love reading your blog!
I have a question for you - when you say "Maximum", does that mean the maximum pre-tax percentage your company will allow? (in my case, 13%). Or do you mean to add your own voluntary contributions up to the maximum dollar amount federally allowed: $15,000/year?

Madame X said...

In my case, I mean I try to contribute the absolute maximum: $15k per year. Some people disagree with this approach, arguing that if you're likely to be taxed at a higher rate in the future, putting that much in a 401k might not be a good approach, and that you're better off just contributing only as much as you need to to get the maximum available matching contribution from your employer.

Ciantgock said...

i'd say the fact that you can compound the money that you aren't paying in taxes now, beats the fact that taxes might be higher in the future.

Anonymous said...

Doing just that! Thanks for reminder :)

-Steven Burda
www.linkedin.com/in/burda

hank said...

Wish I would have started sooner - I've read a couple "worst investment mistake" personal finance blogs lately and this certainly is one of mine - I rolled it over to a land investment last year and hadn't maxed it out yet - but this year it is certainly the goal -

JB @ GetRichOrDieTrying said...

I know I'm coming in a little lot on the topic... however, I have a question that maybe you can answer. Does your company match count towards your contributions?

Ensoleille said...

No, employer matching does NOT count toward your maximum contributions.

Incidentally - I only put into my 401(k) up to what my employer will match (because obviously, if you don't, it's like tossing dollar bills out your car window), but I've had several financial advisors tell me not to put int the full 15k and that I'd be better off investing it elsewhere.

Anonymous said...

Only put in what your employer would match (usually 5%-6% of your salary) if you can't afford to have less money in your bank account. Otherwise, it is pre-tax dollars and the amount you put in the 401k is deductible towards your income so it is preferable to max it out. Those pre-tax dollars can be used to increase your gains in your fund. If you put the money somewhere else, you'll end up with less money to start with. Also when you retire, you'll be in a lower tax bracket since you will not be working anymore (no income).

But I have a different question. If I max out my 401k, am I still qualified to open a ROTH IRA? Or should the combined maximum contribution (401k+IRA) equal $15,500?

Mike said...

I am a new reader... but you know what, I really like how you spelled this out. What you are proposing is really a great way to look at it.

stephanie said...

Your example definitely shows the importance of starting young. You say that you "should at least be able to retire in my early 70s without starving to death." I am 23 do not contribute the maximum to my Roth IRA or my 403(b) (in fact, I only make about 23k per year), but according to most calculators, even if I continue saving at my current rate (about $2500 per year between the 2, plus my employer matches 6.5% on my 403(b)), I should be able to retire in my early 60s and live fairly well off. That is assuming that the only raises I ever get are cost-of-living. Needless to say, I plan on making a greater amount in the future and contributing more to my retirement, but its great to be relatively assured that I can continue at my currently fairly-painless rate of investing and have no problems when I reach retirement age.

sow said...

My wife and I are in the minority here. We don't contribute the max to a 401k and a Roth (or traditional) IRA. Actually, we pulled the plugs on my 401k and her IRA last year. Check out why:
http://www.stewardsofwealth.com/?p=18#more-18
You lose liquidity, utilization, and control of you money.

Let me also give a different perspective here. A 401k grows tax deferred (taxed later) and a Roth IRA grows tax advantaged (invested dollars taxed today with the interest taxed later). If you invest in both, isn't that like driving with one foot on the gas pedal and one foot on the brake? The tax strategies are offsetting each other.

Anonymous said...

Sow - I hope you didn't pull the plug on your roth IRA thinking that it will be taxed in the future. That's the whole advantage of a Roth IRA: The investment ($5000 in 2008) along with the interest and earning are all tax free when you withdraw the money during retirement. Not only that, but your initial $5000 investment in 2008 is your money to take out whenever you'd like for any needs. It's already been taxed, so I guess I would consider that liquidity.

One of the main reasons of having a 401K and a Roth IRA is that it is a tax diversification. You can take some from the 401K (taxable income) and some from the Roth (non-taxed), putting you in a higher overall tax bracket but with only part of that income actually being taxed. Depending on what the future tax rates are, it can add up to significant tax savings.

Ace Custodio said...

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bugbear said...

Maybe put the Roth contribution on monthly autopay at your broker. That way it comes out without you having to "do" anything.

Bill M said...

Agreed, pay your self first through maximizing 401k up to what your company matches, then fund your roth ira when you max it out, go back to 401k

Anonymous said...

Confused! Taxes now or later? Have decided to open a roth ira.

joe said...

I am considering maxing out my 401K this year, but my goal is more of a shelter I suppose. I will be working outside the US and will be eligible for the first 91k of my income tax free. Since my pay will go over that, I am looking at options such as a 401K and IRA contributions to bring the taxable number back under that 91k mark.