The most important thing when it comes to long-term wealth accumulation is that you make consistent investments as soon as possible. The question of where to invest is a natural next inquiry, as simply placing assets in the “right” accounts can make your journey to financial freedom that much shorter.
Here, we’ll look at whether it makes more sense to invest in your 401(k) or IRA first.
Not investments, but tax buckets
A good place to start is to reiterate that 401(k)s and IRAs are not investments unto themselves. They are tax-advantaged accounts that offer opportunities for investment. Usually, in a 401(k), there is a pre-determined list of funds to choose from, while in an IRA, you generally have access to most of the investment universe via stocks, bonds, ETFs, and mutual funds.
The typical 401(k) is a tax-deferred account, whereby you receive a tax deduction today for contributing, and the money can grow unencumbered until you withdraw it in retirement. Some companies offer a Roth 401(k) option, where you’ll pay tax up front and allow the money to grow tax-free through retirement.
Your IRA is a bit different in that it’s opened independently and apart from your employer. A traditional IRA generally has tax characteristics similar to the pre-tax 401(k) and the Roth IRA is tax-exempt in the same way a Roth 401(k) is. IRAs have far lower contribution limits than do 401(k)s, but they have very good uses despite their limitations.
A general roadmap
First, the right decision for you is dependent on your wider financial picture, so be sure to think of the below steps as a very general guide.
Contribute to your 401(k) up to the match
If your company offers an employer matching contribution, it’s financially sensible to take it. Simply put, an employer match indicates that your company will match any contributions to their 401(k) plan up to a specified percentage — typically in the 3% to 5% range of your total compensation.
The matching contribution functions as a 100% return on your 401(k) contribution, so it’s as close to a free lunch as you can expect to receive.
Max out your Roth IRA
Remember that a Roth IRA is an account you open independent from your employer. While the contribution limits aren’t particularly generous — $6,000 for people under 50 and $7,000 for people over 50 — it’s still worthwhile to maximize contributions to tax-exempt vehicles when you have the opportunity.
If you earn beyond the income limits to contribute to a Roth IRA directly, you can look into a backdoor Roth IRA contribution that will ultimately get you to the same place.
Max out your 401(k)
Once you’ve done the first two steps, you can focus on maxing out your employer plan. In 2021, this means contributing $19,500 for the entire year, and $26,000 if you’re over 50.
This is the part where things can become complicated, especially if your 401(k) plan is laden with high administrative fees and you have other goals that require more immediate funding, like a down payment on a first home.
Usually, however, it very much helps to get the absolute most you can out of your tax-advantaged retirement space, and one of the best ways to do that is to maximize your 401(k) contributions every year.
Move on to taxable and other accounts
If you’re able to make it this far, you’re doing the lion’s share of what it takes to retire comfortably. You now can consider investing in taxable brokerage accounts, 529 plans (if you have kids), or a life insurance policy depending on your family setup. You can also focus on building a stronger cash reserve.
The basics matter
If you can commit to maximizing contributions to your workplace retirement plan as well as your Roth IRA every year, you will, by default, be putting yourself in an excellent position to accumulate long-term wealth. Even by doing these things and nothing else, you’ll stand a very good chance of being financially comfortable in a relatively short period of time.
Much of good financial planning is about getting a few key things right. Take the time to learn the mechanics behind 401(k) and IRA contributions and let compound interest take care of the rest.
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