Here at Vanguard, we’re in our busy season. As clients set New Year’s resolutions to save more and prep for submitting their taxes, we receive more phone calls and emails. There’s a tradition at Vanguard where employees from around the organization help out by taking phone calls and processing paperwork. It’s a great way for us to stay in touch with you, our valued clients, and it helps us keep wait times on the phones shorter.
Yesterday, I had the opportunity to spend some time talking with clients, and a question came up from a client in her late twenties looking for guidance on retirement planning:
“I already contribute enough to my 401(k) to take advantage of my company match. Should I continue to invest in the 401(k), or should I open a traditional or Roth IRA?”
Great question—and kudos to this investor for being proactive about her financial future!
Once you’ve made the decision to save for retirement, it can be confusing to figure out the best way to do it.
One of the main benefits of investing pre-tax dollars in 401(k) plans and traditional IRAs is the tax deduction you can receive for the year in which you make the contribution. Roth accounts have a different advantage: Because money is contributed on an after-tax basis, you won’t owe any tax upon withdrawal in retirement. That means any earnings on the money are completely tax-free. For more information, check out this comparison chart of traditional and Roth IRAs.
So, back to the young investor’s question. What type of account should she choose?
Of course, each person’s unique circumstances affect the answer to this question, and there’s no set formula that works for everyone. That said, having money invested in more than one type of retirement account can provide important tax diversification benefits (more on this below) and potentially more flexibility in retirement.
For the young woman I spoke with, one important thing to note is that she’s already contributing enough to her 401(k) to take advantage of her employer match. Many employers match, dollar for dollar, the amount that an employee contributes—often up to 4% or 5%. Once vested, this match provides a 100% return for every dollar invested.
So where should she invest next? For this investor, a Roth IRA could be a great option. Since she’s relatively new to the job market, her earnings are likely lower now than they will be in the future. By contributing to a Roth IRA, she might pay a lower tax rate today than when she’s withdrawing the funds in retirement.
Also, since this client has already invested funds in a 401(k) plan, using a Roth IRA would provide tax diversification.
The idea here is simple. By having both types of retirement accounts, you help mitigate the risk of the unknown. We don’t know what will happen with tax rates in the future (though there’s much speculation that rates will rise). It’s also hard to guess what your personal tax rate will be in the future. Because Roths are funded with after-tax money, they act as a hedge against potentially higher future rates, as you essentially lock in your current tax rate on money contributed.
Tax diversification also gives you more flexibility when making withdrawals in retirement. For example, if withdrawing money from a traditional IRA would put you into a higher tax bracket, you can avoid this bump by taking funds from a Roth IRA instead.*
Many young investors have told us saving can be difficult. With the burden of student loans and new living expenses, combined with the lower salaries that generally come with less experience, finding the money to set aside for your future can seem like an impossible task.
Start by saving a small amount. Every little bit really does count. Set up an automatic saving plan and gradually increase the amount withdrawn from your paycheck over time. The best thing young investors have on their side is time. Through the power of compounding, saving a little now may pay off big later.
*Please note, when taking withdrawals from an IRA before age 59-1/2, you may have to pay ordinary income tax plus a 10% federal penalty tax.