Ask Kim
Retirement Saving Options
Which should I do first: invest in my 401(k) at work or open up a Roth IRA?
By Kimberly Lankford, Contributing Editor, Kiplinger's Personal Finance
April 13, 2006
I'm 30 years old and earn about $40,000 per year. Most of my paychecks go toward my apartment, student loans and car payments. I'd like to start saving for retirement but don't have a lot of money to invest. Which should I do first: invest in my 401(k) at work or open up a Roth IRA?
If your employer matches your 401(k) contributions, then that should be your first saving priority. It's free money that you won't get anywhere else. And because your 401(k) contributions lower your taxable income, they won't reduce your take-home pay by nearly as much as you'd expect.
If your employer matches 50 cents on the dollar for up to 6% of your salary -- a typical matching contribution -- you'll get the maximum match if you contribute $2,400 for the year. That gives you a free $1,200 from your employer, transforming your $2,400 contribution into $3,600.
And that doesn't count the tax benefits. Because you're investing the money before you pay taxes on it, a $2,400 contribution will only reduce your take-home pay by $1,800 if you're in the 25% tax bracket.
When you add up the tax benefits and the matching contribution, your contribution expands significantly. It actually costs you just $150 per month to end up with a $3,600 contribution every year. If you continue at that pace every year and your investments earn 8% per year, you'll have about $670,000 by the time you're age 65 -- just from contributing $150 per month.
That gives you a great head start on your retirement savings, but it won't be enough to fund all of your retirement expenses. After you've invested at least up to the employer match in your 401(k), then you can use any extra money to open a Roth IRA.
Single people earning less than $110,000 for the year and married couples earning less than $160,000 can contribute up to $4,000 in a Roth this year. Your contributions aren't tax-deductible, but your earnings will be tax-free in retirement. If you can afford to invest $200 per month in a Roth IRA for the next 35 years, you could end up with more than $440,000 of tax-free money at age 65.
As your income increases or your expenses decrease -- after you pay off your student loans, for example -- use the extra money to boost your retirement contributions. Also add some extra money when you get a bonus at work, tax refund, gifts or other money you weren't expecting. Because you've gotten used to living without that money already, it's much easier to invest it before you have an opportunity to spend it on something else.
For more information about saving for retirement and setting your goals, see How Much Is Enough? For information about starting an IRA, see Why You Need a Roth IRA. Also see Max Out Your 401(k) and An IRA Owner's Manual.
