When most people plan for retirement, they commonly believe they have to choose between either contributing to a 401(k) and a Roth IRA. But, as financial advisor D. Paterson Cope explains, the two popular retirement plans are not mutually exclusive.
In fact, there are many benefits people can realize by using these two types of accounts together. It can help you maximize the benefits each type of account offers while more effectively planning for retirement.
Here are some reasons why:
401(k): Employer Matches
Most 401(k) plans are employer-sponsored. While it’s not as common as it once was, many employers still provide their employees with a match to 401(k) plans. This is an ancillary benefit provided to employees that not only can serve as a recruiting and retention tool, but also as a way to encourage employees to save for retirement.
In these cases, the employer will match employees’ contributions. Typically, it’s dollar-for-dollar up to a certain percentage of an employee’s salary. As an example, let’s say the employer match is 4%, and that equates to $50 per week for a particular employee.
This would mean that, as long as this employee contributes 4% of their salary to the 401(k) plan, the company will also contribute another 4%. That’s basically a free $50 per week the company will contribute to the employee’s retirement plan, or $2,500 per year.
401(k): Lower Tax Liability
Another big benefit of a 401(k) is you can lower your current tax liability. That’s because all contributions made to a 401(k) plan are done on a pre-tax basis. This means that your taxable income is lowered.
Let’s again use the example of a person with a $50,000 annual salary. If the person contributes 4% of their salary to a 401(k), that equates to $2,000. Since that is done on a pre-tax basis, the person’s taxable income would be reduced to $48,000 for the year, just based on their 401(k) contributions.
Roth IRA: More Choice
One of the downfalls of an employer-sponsored 401(k) plan is they often have limited investment choices. Your employer will choose the investment company that will hold the assets and run the plan. That investment company will then choose which funds are available for you to invest in.
If you’re looking for a wider selection of investments, a Roth IRA could be a great choice. You’d be able to select your own investment company and then be presented with many more funds in which you could invest.
Roth IRA: Tax-Free Earnings
A Roth IRA works the opposite way a 401(k) does. You make contributions after you pay taxes on your money, but then your investment balance can grow tax-free.
When you withdrawal earnings from a Roth IRA, you don’t have to pay taxes on it, since you did that before you made contributions in the first place. When you withdrawal from a 401(k), by contrast, you have to pay taxes. That’s because you got a tax deferment when you made the contributions.
As D. Paterson Cope explains, by combining a 401(k) plan with a Roth IRA, you’ll be getting the best of both worlds. You’ll be taking advantage of employer contributions and lowering your tax liability now, while also enjoying more investment choices and having some of your earnings grow tax-free.
About D. Paterson Cope
Paterson Cope, CFP® is the founder and CEO of Cope Private Wealth, a financial planning and wealth management firm specializing in assisting retirees and people who are about to retire. D. Paterson Cope has been providing financial advice for more than 30 years. He first earned the designation of Certified Financial Planner (CFP) in 1997. When he isn’t working, he enjoys spending time with his wife, Jennifer Miree Cope, and the rest of his family in Mountain Brook.
