Rule of Thumb—Should You Fund Your 401(k) First, or Your Roth IRA?

These simple recommendations make retirement savings easier

graphic showing two people on top of stack of books with a ruler and pencil. the words "financial rules of thumb" are in the middle

Joyce Chan / The Balance

Financial planners say you should aim to contribute at least 15% of your pre-tax income to 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. In this article, we’ll dive deeper into when you should use each, and how to structure your retirement contributions for maximum benefit.

Key Takeaways

  • Contributing as much as you can—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 go back to your 401(k).
  • This strategy makes sure 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 Where to Invest Your Retirement Savings?

If your employer offers a 401(k) match, withhold as much you need from your paycheck to max out that match. This may take some time, but once you’ve met that goal and are meeting your employer’s match on a regular basis, focus next on Roth IRA contributions. Then, if you max out your Roth IRA, go back to your 401(k) and withhold more from your paycheck 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 take advantage of company matching upfront, then 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, like retirement savings, 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 As the account grows, gains on investments are tax-deferred until the money is withdrawn.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 get free money for your retirement. Some companies pay in 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.

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

Check with your human resources department or review a copy of your employee handbook to find out about your company’s 401(k) matching program so you can calculate the amount you need to contribute to get the full match.

Your employer’s matching contributions are only yours if you stay with the company for a certain amount of time. If you leave before your 401(k) is vested, you’ll lose some or all of the matched contributions. 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 (more about eligibility requirements in the Grain of Salt section below). If a Roth option is available in the 401(k), an individual should fund the Roth 401(k) before attempting to contribute to the Roth IRA account. This is due to the lack of income limitations.

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. In 2021, you can save up to $6,000 in a Roth IRA, or $7,000 if you’re age 50 or older by the end of the year. If you can afford it, contribute the maximum every year.

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, for example, without incurring the usual 10% tax on early distributions. These exceptions make the Roth IRA a vehicle you could draw on for a down payment or for an emergency if you didn’t have other savings. 

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 once you retire.

Return to the 401(k)

You can contribute a maximum of $19,500 to your 401(k) in 2021. Employees over age 50 can make an additional $6,500 catch-up contribution. Once you’ve made enough 401(k) contributions to meet the company match, and you’ve reached the annual Roth IRA contribution limit, then go back to your 401(k) and contribute any additional amount you can this year.

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, if you can afford to make additional retirement contributions, you can stash more funds in your 401(k) and get additional tax benefits, up to the annual limit. It’s a straightforward plan that takes the guesswork out of retirement savings.

Grain of Salt

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. If that’s the case for you, you’ll still want to follow the order of the priorities laid out in the rule, but you might just not be able to max out your 401(k) in Step 3 above, for instance.

Another thing to keep in mind is that Roth IRA contribution limits are lower for high earners. For 2021, single filers and heads of households can make the full contribution if their modified adjusted gross income (MAGI) is below $125,000. Between $125,000 and below $140,000, a reduced contribution is allowed; if your MAGI is equal to or above $140,000, you cannot contribute to a Roth IRA at all. Although there are limitations based on level of income when contributing to a Roth IRA, an individual can still contribute to a Roth 401(k) if the option is available in the 401(k) offered. Level of income would not be a barrier for saving in an after-tax account.

If your filing status is married-filing-jointly, you can make the full contribution for MAGI below $198,000. Between $198,000 and below $208,000, a reduced contribution is allowed. If MAGI is equal to or above $208,000, you cannot contribute to a Roth IRA.