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What to Do with Extra Retirement Savings -- Into a 401k or Roth IRA?

Anthony Lazaro, 27, is trying to figure out how much of his retirement savings to contribute to his 401k and how much to a Roth IRA.


For several years, on the advice of his mother's financial planner, he has saved in a Roth IRA. However, he recently became eligible to participate in his employer's 401k plan, which includes a matching contribution.

"One of the appeals of going toward the 401k is the free money" from the employer matching contribution, said Lazaro, a Durham, N.C., resident. "I have not participated in the 401k yet because I do have those other funds started. Should I start up a 401k? If so, which should get more attention, the Roth or the 401k?"

Good questions, Anthony.

When considering the retirement savings tools available to workers -- employer-sponsored plans, traditional IRAs and Roth IRAs -- it can be hard to determine what's best for you.

Indeed, a recent study contends that for some people, saving in a Roth or even in a taxable brokerage account in addition to a 401k could reduce the amount of taxes paid over a lifetime. More on that in a minute.

What should you do?

Unfortunately, there's no one-size-fits-all answer. But guidelines are available to help you decide. These guidelines are a starting point. If your financial situation is complex, consider consulting a financial professional such as a certified financial planner (CFP) or certified public accountant (CPA).

This discussion is academic if you aren't saving at all. If you aren't saving, get started! Then you can wrangle over these tax questions.

401k Match

If your employer matches your contributions to your 401k plan, that's the first place to direct your savings, financial experts say.

"You should always make a large enough deposit to the 401k to get the full match," said Robert Weagley, a certified financial planner and professor of consumer and family economics at the University of Missouri-Columbia. "If you aren't, you are leaving money on the table," he said.

According to the Plan Sponsor Council of America's 44th Annual Survey of profit-sharing and 401k plans, more than 70 percent of employers polled offered a matching contribution. The percentages matched vary from plan to plan.

Say your employer offers a match of 25 cents on the dollar on the first 3 percent of salary you contribute to the plan. "That's a guaranteed 25 percent return right off the bat," said Steve Wimmers, a CPA in San Diego and first vice-chair of the California Society of CPAs. "That's better than the market is providing."

Lazaro plans to start contributing 10 percent of his salary to his 401k -- more than enough to get his plan's full match. Beyond that, he expects to have an additional $300 a month to save. The question is where to put it -- in the 401k or in a Roth IRA?

Tax Issues

If, like Lazaro, you are mulling where to put additional savings after maxing out your employer match, often the answer lies in where your money will get the best tax treatment.

It's helpful to have an idea of what your tax bracket will be in retirement compared to today, and whether you prefer to pay taxes today or in retirement.

When you save in a traditional IRA or 401k plan, contributions today reduce your taxable income today, but you pay the deferred income tax when you withdraw your contributions and earnings in retirement. When you save in a Roth IRA, you forgo today's tax break, but you never pay any taxes on your qualified withdrawals from the account.

From a strictly income-tax-bracket perspective, the Roth has an advantage over the 401k only if you expect to be in a higher tax bracket in retirement, because that would mean the taxes you pay today are less than you expect to pay in the future.

A study released last year raised another tax argument in favor of the Roth for extra saving: 401k investment returns could push up the income of some workers enough to penalize them in retirement. This conclusion was published by Laurence Kotlikoff, chairman of Boston University's economics department, and Jagadeesh Gokhale, senior advisor, and Todd Neumann, researcher, both of the Federal Reserve Bank of Cleveland, in their study "Does Participating in a 401k Raise Your Lifetime Taxes?"

They concluded, "while contributing to retirement accounts (such as a 401k) lowers current taxes, the increase in taxes paid on the withdrawal of accumulated contributions can exceed the immediate tax reduction when measured in present value."

The study contends than low- and middle-income workers may end up paying more taxes over a lifetime by saving in a 401k, while people with higher incomes pay fewer taxes over a lifetime by saving in a 401k.

Here's how, according to the study. Recall that 401k withdrawals are taxed as income. In comparison, long-term investments in a taxable stock account are taxed at the lower long-term capital gains rate. (This benefit could be negated if you hold mutual fund investments that make capital gains distributions at year-end.) And qualifying Roth IRA withdrawals are not taxed at all in retirement. The tax-deferred accounts inherently have a higher tax burden, in many cases.

Further, shifting the taxes on your income to your retirement from working life could "substantially increase the share of Social Security benefits subject to taxation," their paper said.

Finally, reducing taxable income during your working years could negate some of the value of mortgage interest deductions for young homeowners.

One Strategy

As we said earlier, you should consult with a professional to develop the best strategy for you.

But, here's a strategy to consider:

Contribute enough to your 401k plan to get the full match, if your employer offers one. Then, if you have any additional money you would like to save, and if you qualify, make a full Roth contribution. Finally, put any additional savings into your 401k. But, you will likely need to follow a budget and be organized so that you can juggle all the contributions.

This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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