Roth IRA vs. 401(k) for 20-Something Saver

Dear Dr. Don, I am 28 years old, earning $23,000 a year, so I currently live at home. I have a 401(k) plan that I've been contributing into, for a little over three years. It's worth about $8,500, and I contribute 8.5% of each paycheck into it. I also have a small Roth IRA invested in a mutual fund with approximately $1,100 in it. I have $12,000 in savings. I'm saving up for when I will eventually be able to move out and purchase a condo or home. My question is: Should I decrease my 401(k) contribution and put more into my Roth IRA?

I'm assuming I'll be in a higher tax bracket when I retire, so I'm wondering if it makes sense to pay taxes on my contributions now, rather than get the tax advantage through my 401(k). I just want to make sure I'm doing as much as I can right now in order to take advantage of my greatest asset -- time.

Thank you, -- Greg Groundfloor

Dear Greg, If your employer offers a matching contribution to your 401(k) plan, then I'd suggest that you contribute up to the limit of the matching contribution before you start thinking about funding a Roth IRA. If the employer contributes 50 cents for every $1 you put in, you're making 50% on your contributions to the plan -- up to the limit of the match.

When an employer offers matching contributions, it's typically 50 cents per $1 contributed by the employee, up to 6% of salary. You're now contributing 8.5% of your salary, so even if there is a match you could easily dial back your 401(k) contributions and shift some of your retirement savings into your Roth IRA.

With a Roth IRA, you fund the account with after-tax dollars, and qualified distributions out of the account are tax-free in retirement. In contrast, your 401(k) contributions are tax-deferred, and you'll owe income taxes on the qualified distributions out of the account in retirement.

There's also the ability to withdraw up to $10,000 from a Roth IRA as a first-time homebuyer. In general, the account has to have been established and funded for more than five years for the account owner to utilize the first-time homebuyer provision and not owe a 10% penalty tax on the distribution of any investment earnings. If you're not planning to buy a home for at least five years, you could move some of the $12,000 you have in savings into the Roth IRA. You just have to stay below the annual contribution limits for these accounts.

In general, it makes sense to fund a Roth IRA if you expect to be in a higher tax bracket in retirement than you're in when you fund the account. You say you're in that situation. Just don't ignore the "free money" aspect of any employer matching contributions to your 401(k).

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