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Assuming you meet the qualifications to set up a Roth IRA, how do you decide where to put your retirement savings each year?

A Roth IRA will generally be more beneficial for individuals who are far away from retirement and whose projected tax rate in retirement will be higher than it is now. It will also likely be better for people who plan to continue working past age 70. It can be used as a supplemental way to save once the maximum annual pre-tax 401(k) contribution has been made to a plan with a company match.

IMPORTANT NOTE: The maximum annual contribution to a Roth IRA is only $6,000 in 2020 ($6,000 in 2019) plus catch-up contributions if you are at least age 50. The current maximum annual contribution to a 401(k) plan for non–highly compensated employees set by the IRS is considerably higher.

By comparison, retirement plan accumulations in a 401(k) plan that you contribute to and that has an employer match, should exceed retirement accumulations that can be attained within a Roth IRA. However, a Roth IRA contribution is almost always better than an unmatched after-tax 401(k) contribution.

Both contributions are nondeductible, but tax-free distributions may be made from a Roth IRA if held for at least 5 years and if made on or after you reach age 59½, or because of death or disability. Also with regard to Roth IRAs, tax-free, penalty-free distributions, subject to a $10,000 lifetime limit, are allowed for first-time homebuyers.

If the 401(k) contribution is unmatched but pre-tax, then the answer depends on how your tax rate is expected to fluctuate upon retirement. If your tax rate will increase in retirement, the Roth IRA is usually more favorable. If your tax rate will decrease in retirement, the 401(k) may be more beneficial. Also consider the choice of investment channels made available by the employer in a 401(k) plan and the ability to take a loan against your account balance. In a Roth IRA, you can invest in a wider range of assets, but loans are not permitted.

If you are not eligible to establish a Roth IRA, contribute the maximum pre-tax contribution to your company retirement plan first. If you have additional money to save, and you are eligible to make a tax-deductible contribution to a traditional IRA, do that next.