How To Structure Your Retirement Contributions for Maximum Benefit (2024)

Financial planners say that you should aim to contribute at least 15% of your pre-tax income to saving for retirement but weighing exactly what kinds of accounts to put your money in, and when, can be paralyzing. Fortunately, there's a rule of thumb for optimizing two kinds of accounts—a 401(k) and Roth IRA or Roth 401(k)—that makes sense for most people.

Key Takeaways

Contributing as much as you can and at least 15% of your pre-tax income is recommended by financial planners.
The rule of thumb for retirement savings says you should first meet your employer's match for your 401(k), then max out a Roth 401(k) or Roth IRA. Then you can go back to your 401(k).
This strategy makes sure that you get the free money from your employer first, then begin as early as possible to grow savings tax free in a Roth IRA or Roth 401(k).

What Is the Rule of Thumb for Investing Retirement Savings?

Contribute as much you can from your paycheck to max out the match if your employer offers a 401(k) match. This may take some time but focus next on Roth IRA contributions after you've met that goal and you're meeting your employer's match on a regular basis. Then go back to your 401(k) and withhold more from your paycheck if you max out your Roth IRA. Keep at it until you've reached the annual limit for employee contributions.

How To Use This Retirement Savings Rule of Thumb

This rule of thumb ensures that you'll take advantage of company matching upfront, then it allows you to make additional retirement contributions where you get the best tax benefits. Following a specific set of steps for a long-term plan keeps you on track and eliminates the need to refigure your plan every year.

Get Your 401(k) Match

The 401(k) is an employer-sponsored retirement account to which employees can contribute pre-tax salary. As the account grows, gains on investments are tax deferred until the money is withdrawn. Many employers will match at least some portion of their employees' 401(k) savings, which means you'll get free money for your retirement.

Note

Some companies pay a portion of employees' pre-tax contributions up to a certain amount, which is often a percentage of their salary. All you have to do to get the match is make the contributions.

Let's say that your employer offers to match 50% of your contributions, up to 3% of your annual salary. That means that your employer will kick in an additional 3% ($3,000), bringing your total retirement savings to $9,000 a year if you earn $100,000 a year and contribute 6% ($6,000) of it to your 401(k).

Your employer's matching contributions are only yours if you stay with the company for a certain period of time. You'll lose some or all of the matched contributions if you leave before your 401(k) is vested. Your own contributions are always yours.

Fund Your Roth IRA

Once you've earned the full company match on your 401(k) contributions for the year, focus on maxing out annual Roth IRA contributions if you're eligible. Due to the lack of income limitations, you should fund the Roth 401(k) before attempting to contribute to the Roth IRA account if a Roth option is available in the 401(k).

A Roth IRA allows you to make post-tax contributions, but you won't pay taxes on gains, including dividends, capital gains, and interest earned. The sooner you get your money into the Roth, the longer it will have to compound tax free. You can save up to $6,000 in a Roth IRA in 2022, or $7,000 if you're age 50 or older by the end of the year. This increases to $6,500 (or $7,500 if you're age 50 or older) in 2022. Contribute the maximum every year if you can afford it.

The Roth IRA also offers flexibility to avoid additional taxes on certain distributions before retirement. You can withdraw money to purchase your first home (with limitations) or for certain medical expenses without incurring the usual 10% tax on early distributions. These exceptions make the Roth IRA a vehicle that you could draw on for a down payment or for an emergency if you didn't have other savings.

Note

The Roth IRA doesn't allow you to take an upfront tax deduction like a traditional IRA, but you can withdraw from it tax free when you retire.

Return to the 401(k)

You can contribute a maximum of $20,500 to your 401(k) in 2022, increasing to $22,500 in 2023. Employees who are over age 50 can make an additional $6,500 catch-up contribution. Go back to your 401(k) and contribute any additional amount you can this year once you've made enough 401(k) contributions to meet the company match, and you've reached the annual Roth IRA contribution limit.

You won't get an additional company match on these extra contributions, but you'll still make pre-tax contributions to your retirement savings.

Why This Rule of Thumb Generally Works

This rule of thumb works for most people because it first prioritizes maxing out the employer match to make sure you don't miss out on free money. Then it prompts you to get your money into the Roth IRA so the money has the maximum amount of time to grow tax free. Finally, you can stash more funds in your 401(k) and get additional tax benefits, up to the annual limit, if you can afford to make additional retirement contributions.

It's a straightforward plan that takes the guesswork out of retirement savings.

A Grain of Salt: Roth IRA Contribution Limits

Not everyone can spare the money needed to fully max out two or more retirement accounts, so you might not achieve all the steps of this plan. You'll still want to follow the order of the priorities laid out in the rule if that's the case for you, but you might not be able to max out your 401(k) in Step 3 above.

Another thing to keep in mind is that the Roth IRA contribution limits are lower for high earners. Single filers and heads of households can make the full contribution if their modified adjusted gross income (MAGI) is below $129,000 in 2022. A reduced contribution is allowed if you earn between $129,000 and below $144,000. You can't contribute to a Roth IRA if your MAGI is equal to or above $144,000.

These thresholds are also indexed for inflation, and they increase in 2023. Single and head of household filers can make the full contribution on incomes of less than $138,000. They can make a reduced contribution on incomes from $138,000 to $153,000 and they can no longer contribute if they earn $153,000 or more.

Note

These limits increase if you're married and filing a joint return with your spouse. The 2022 limit for contributing the full amount is $204,000 in this case, increasing to $218,000 in 2023. Partial contributions are permitted on incomes of $204,000 to $214,000 in 2022, increasing to $218,000 to $228,000 in 2023. You can't contribute if your joint income is $214,000 or more in 2022, or $228,000 or more in 2023.

Although there are limitations based on level of income when contributing to a Roth IRA, you can still contribute to a Roth 401(k) if the option is available in the 401(k) offered. The level of income would not be a barrier to saving in an after-tax account.

Frequently Asked Questions (FAQs)

How much should I contribute to my 401(k) before I add to a Roth account?

This will largely depend on your employee benefits package. It's in your best interest to contribute the full amount that your employer will match to take advantage of the free money if you have a 401(k) with an employer match. Talk to your HR department for details of your specific plan offerings.

Can I max out my 401(k) and my Roth IRA in the same year?

Yes, you can contribute the maximum to these accounts in the same year, given any income-based limitations set by the Internal Revenue Service (IRS). Keep in mind, however, that there's an overall limit for IRA contributions. Your combined contributions to these accounts cannot exceed the yearly limit if you have both a Roth and a traditional IRA. Defined contribution plans like 401(k)s don't fall under this umbrella.

As an expert in personal finance and retirement planning, I can attest to the importance of a strategic approach when it comes to saving for retirement. The article you provided offers a valuable rule of thumb for optimizing contributions to retirement accounts, specifically focusing on 401(k)s and Roth IRAs or Roth 401(k)s. This strategy is based on sound financial principles, and I'll break down the key concepts used in the article to help you understand and implement this rule effectively.

Contributing at Least 15% of Pre-tax Income: Financial planners commonly recommend contributing at least 15% of your pre-tax income towards retirement savings. This ensures a substantial and consistent effort to build a nest egg for the future.
Prioritizing Employer's 401(k) Match: The rule of thumb suggests starting by contributing to your employer-sponsored 401(k) up to the match limit. This is crucial as it allows you to take advantage of free money from your employer, which often matches a percentage of your contributions.
Maxing Out Roth IRA Contributions: After meeting the employer's match, the next step is to focus on maxing out contributions to a Roth IRA. Roth IRAs offer tax-free growth, and contributions can be withdrawn without penalties, providing flexibility.
Utilizing Roth 401(k) if Available: If your employer offers a Roth 401(k), it's recommended to contribute to it before maxing out the Roth IRA. This takes advantage of tax-free growth while accommodating a higher contribution limit compared to a Roth IRA.
Returning to Contribute to 401(k): Once Roth IRA contributions are maximized, return to contributing to the 401(k) until reaching the annual limit. While this won't yield additional employer matches, it allows for additional pre-tax contributions with potential tax benefits.
Rationale Behind the Strategy: This rule of thumb is designed to optimize retirement savings by first securing employer matches, then leveraging the tax advantages of Roth accounts, and finally maximizing pre-tax contributions within the limits set by the IRS.
Considerations for Roth IRA Contribution Limits: The article acknowledges that not everyone can fully max out multiple retirement accounts. Additionally, high earners may face limitations on Roth IRA contributions based on income levels, with specific thresholds that increase annually.
FAQs: The article addresses common questions, such as the importance of contributing to a 401(k) before a Roth account, and confirms that it's possible to max out both a 401(k) and Roth IRA in the same year, subject to IRS limitations.

In conclusion, following this rule of thumb provides a systematic and effective approach to retirement savings, ensuring that individuals capitalize on employer matches, tax advantages, and contribution limits to build a robust financial foundation for their later years.