The only way not to think about money is to have a great deal of it.   

(Edith Wharton)

Choices are a common by-product of a capitalist society.  Unfortunately, this often leads to the paradox of choice wherein more leads to less: less happiness, less satisfaction and possibly (more) confusion and paralysis.

Launched in 1980, the original 401k has become the default retirement savings account for many workers, especially in the private sector.  Since then, every decade or so has ushered in more variations: Roth 401k, after-tax 401k.  Further competing for workers’ retirement savings are ESPP (Employee Stock Purchasing Plan). Also, in the background are retirement savings options for individuals and small businesses: Traditional IRA, Roth IRA, SEP IRA, Simple IRA, Solo 401k.  No wonder some workers feel like they’re downing in a alphabet soup of plan options.

Inversely, since pensions are becoming a relic, it’s more critical that workers choose the right plan(s) to save (tax) efficiently and effectively for retirement.  As a financial planner, I often see W-2 clients try to hedge tax burden by splitting contributions between a pre-tax 401k and a Roth 401k.  The thinking is the former account will allow them to enjoy some tax savings now via tax-deductions while the latter will allow them to enjoy tax “savings” later when assets are withdrawn tax-free.  After all, taxes are likely going up, right?  (FYI, this has been the ongoing assumption for decades now.  Truth is, tax rates have been trending down.)

Max out tax-deductible 401k first

While the thinking (above) is correct, the execution can be optimized further.  It’s said that when buying a house, it’s best to do so with a selling (or exit) strategy in mind.  This is also the case with retirement savings.  When saving for retirement, it’s best to consider the income withdrawal strategy to help control/limit taxes and, thereby, extend savings by years, if not decades.  One of the best ways to do so is by divvying up retirement savings into different types of accounts (aka “locations”):

     ·      Tax-deductible or pre-tax accounts: 401k, 403b, 457, Traditional IRA

     ·      Tax-free or post-tax accounts: Roth 401k, Roth 403b, Roth IRA

     ·      Taxable account: brokerage  

In my opinion, for most W-2 workers, the simplest and best strategy is to max out your tax-deductible (or pre-tax) 401k first.  (In other words, not the Roth 401k.) Here are the key benefits for doing do:

     ·      You get your tax-savings now by lowering income tax.

     ·      You likely receive an employer match (free money) on top of your contribution.

     ·       By building up a nice pre-tax nest egg, you have a great opportunity to convert a portion of it to Roth IRA (tax-free money) during pre- or early retirement years when you’re likely in a lower tax-bracket.

            

Max out tax-free Roth IRA next   

Once you’ve maxed out your tax-deductible (or pre-tax) 401k, if you still have leftover savings, then consider opening and investing in an individual Roth IRA with a big-name financial custodian: Vanguard, Fidelity.  This strategy is better than splitting work-place contribution between a (pre-tax) 401k and Roth 401k:

     ·       It allows you to put the maximum tax-deductible amount ($19.5K) into your 401k.  (Enjoy more tax savings now.)

     ·      You’re still able to contribute $6K to a tax-free Roth IRA.  (Enjoy tax benefits later when you withdraw funds tax-free.)  

             NOTE: For those with Modified Adjusted Gross Income (MAGI) over $140K (single) and $208K (married), you can do a backdoor Roth IRA.

     ·   You increase total annual contribution to a tax-deductible and tax-free account from $19.5K to $25.5K.

      NOTE: If you’re age 50 and over, you have catch-up benefits where you’re able to contribute $26K to your 401k and $7K to Roth IRA.