Retirement savings accounts, like 401(k) and Roth IRA accounts, are excellent tools to help Americans save for a comfortable retirement. It’s not enough to merely have an account. If you want to make the most of your IRA or 401(k) account so you can truly live out the retirement you’ve always dreamed of, there are a few key things to keep in mind. In this post, we’ll go over what you need to know about IRA and 401(k) optimization.
Roth IRA vs. 401(k)
Before you can start optimizing your retirement savings, it’s vital to understand the major differences between a 401(k) and Roth IRA account so that you can choose the account that aligns best with your goals.
401(k) accounts are usually sponsored by an employer. You pay taxes on the earnings when you withdraw them in retirement. This means you’ll pay whatever rate your tax bracket is taxed at during the time of withdrawal. 401(k)s are funded with pre-tax dollars that are diverted from your paycheck. This has the advantage of lowering your taxable income every year you contribute to the 401(k)—also, many employers do a 401(k) match; these matches are also tax-advantaged.
Conversely, your Roth IRA account is funded with after-tax dollars. This allows the money to grow tax-free. Another difference is that you are free to withdraw your contributions (not your earnings) from your Roth IRA at any time without having to pay a tax penalty. The penalty for early withdrawals for 401(k) accounts is usually 10%.
The other main difference when talking 401(k) vs. Roth IRA is the contribution limits. For 2022, Roth IRA contributions can’t exceed $6,000 for people under age 50 or $7,000 for those at or over age 50. For 401(k) accounts, you can contribute up to $20,500 in 2022 if you are under age 50 and $27,000 for those at or over age 50—a pretty stark difference from the Roth IRA contribution limits.
401(k) optimization
To make the most of your 401(k) you should:
Get an employer match
The easiest way to maximize your 401(k) contributions is to make sure your employer is matching—or at least contributing—to your account. If they’re not, you may want to consider finding a new employer or finding a new retirement account option.
Don’t make early withdrawals
You will likely switch jobs a few times throughout the course of your career. You can choose to roll your 401(k) over to a new account or let it be and allow it to keep growing. Just keep in mind that your old employer will stop matching your contributions once you are no longer employed by them. We know switching jobs, and 401(k)s may seem like an opportunity to cash out. But, avoid this temptation at all costs. You’ll only end up hurting yourself in the form of a big tax penalty and compromising your retirement down the road.
Diversify your assets
Minimize the risk of your 401(k) losing money by choosing a well-diversified portfolio. The closer you get to retirement, the more you should shift your portfolio to less volatile investments.
Roth IRA optimization
To make the most of your Roth IRA, you should:
Start saving early
The earlier you start contributing to your Roth IRA, the more money you’ll have in the future, thanks to compounding. Even if you are unable to contribute the maximum amount right away, anything is better than nothing. Even the smallest investment will expand your nest egg if it has time on its side.
Don’t wait until April 15
Some investors only make contributions to their Roth IRA accounts on Tax Day. But, waiting like this means you’re not giving your contribution a fair chance at growing. What’s more, you risk making your investment at a high point in the market.
Instead, make your contribution at the beginning of the year so that it has more time to grow and compound. Or, make smaller monthly contributions for less of a hit at one time while still allowing your contributions time to grow.
Use a backdoor IRA
Some people will want to exceed the contribution limits for their Roth IRA accounts. You can do this by using a backdoor IRA account. This basically means that you turn the contribution process into two steps:
- Step 1: Make a non-deductible contribution to a Traditional IRA
- Step 2: Convert your contribution to a Roth IRA
It’s as easy as that, and you can start contributing far more than the Roth IRA limits to secure your retirement.
