Have you ever taken the time to really compare your options when investing for retirement? Have you looked at the main differences between the best tax-sheltered accounts? When making financial decisions it’s always a good idea to look at the alternatives and consider the pros and the cons of each option. There are two different investment vehicles to consider when saving for retirement. They are the 401(k) and the Roth IRA. Most people like to look at taxes when comparing the two but there are other factors to think about. Both can be beneficial to your bottom line in the long-term. But how should you choose between the two? Let’s go to the tale of the tape and discuss each in more detail.
A 401(k) offers you the ease of having your contributions deducted straight from your paycheck so you never actually even see the money hit your check book. This is a great feature to keep you on track to continue to save for retirement. You receive an immediate tax break since your contributions are made on a pre-tax basis. You will then have to pay ordinary income tax rates when you retire and start to make withdrawals from your account. If you expect your tax rate to be lower in retirement than it is now, a 401(k) is more efficient on the tax front.
On the other hand, your Roth IRA contributions are made with after-tax dollars. So when you retire you will pay no taxes on the distributions from your account. If you expect to be in the same or a higher income tax bracket when you retire then investing within a Roth IRA is the best choice for tax purposes. You do have to go through the process of setting up an account with a fund company to make your contributions. Granted this is an easy process that can be
done online, but it’s a little more work than is required for your 401(k) setup.
There are other factors to consider as well. Since you already paid taxes on your Roth contributions you can withdraw them without paying income taxes or an early withdrawal penalty. With a 401(k) you must pay taxes as well as a 10% penalty for early withdrawal. I don’t recommend taking money out of your retirement accounts but in an emergency this is a nice option to have with the Roth.
Your investment options in a 401(k) are also limited by the selections made by your employer. They may have terrible fund choices without any low-cost index fund options. Any fund company will have a diversified choice of fund options you can select from with a Roth IRA. Unfortunately to be eligible to make Roth contributions the upper adjusted gross income limit is $188,000 for married couples ($127,000 for singles).
So which one is the best option? If you make the decision strictly based on taxes the 401(k) makes the most sense since your taxes will generally be lower when you retire. But here’s the thing. We don’t know what the jokers in Washington D.C. are going to do with tax rates in the future. Your guess is as good as mine.
It actually makes sense to make use of both of these tax shelters. Just as you should invest in a diversified portfolio to spread your risks you should also diversify your tax benefits. By using a combination of both accounts you get to spread out your risk of a changing tax structure by using some benefits now and some in retirement. And once you do retire and need to use your investment dollars for spending needs you will have the ability to choose from taxable and tax-exempt options.
You should always start by funding your 401(k) to get the maximum amount for your company’s match. The average match is around 3-4%. That’s an easy 100% return on your investment so you should never miss out on that. So let’s assume you put 4% of your pay into your 401(k) to get the company match.
You would then move on from there to fund your Roth IRA. You can contribute up to $5,500 for 2013 tax purposes. If you are in the position to have enough left over after getting your company match and completely funding your Roth IRA you can then increase the amount of your 401(k) contribution. That limit is $17,500 for the 2013 tax year.
The main objective when making financial decisions should not necessarily be to make the perfect choice because that will be difficult to do on a consistent basis. What we should be striving for is to make choices that will increase the odds of accomplishing our goals. Having a diversified portfolio by investments
and tax shelters will do just that.
Ben Carlson writes about personal finance, investments and investor psychology at A Wealth of Common Sense.