Posts

March 2013
SMTWTFS
« Feb Apr »
 12
3456789
10111213141516
17181920212223
24252627282930
31 

Should You Have a 401(k) or Roth IRA?

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.

Subscribe and Get Email Updates for Free!

Enter Your Name and Email Address Below:

9 comments to Should You Have a 401(k) or Roth IRA?

  • Great review of the 401K and Roth IRA options. Recently they have come out with the Roth 401k option as well. I have been able to take advantage of this option as we do not qualify for the Roth IRA option.
    Brick By Brick Investing | Marvin recently posted..How To Use Trailing Stops

  • Thanks. Good point on the Roth 401(k). I actually just had that option added to my company’s plan as well. Another option if you do not qualify for the Roth is to contribute to a traditional IRA and then make the conversion to a Roth. But the Roth 401(k) is the much easier route in this case.

  • The immediate tax break of a 401(k) seems to be a major factor for many joint households. Company plans can be strangely convoluted, as well.

  • That’s crazy Derek, I just finished part 1 of a 2 part series on my website to discuss just this (a mere 4 days before you, LOL).
    As they say, great minds think alike, and hopefully I’m in the same category as you sir. :-)
    I’m still working on part 2 and will hopefully be done soon.
    Chris recently posted..Choosing a Roth IRA or 401k for investment purposes

    • Chris, did you come to any different conclusions that I did for this post? I’m always curious if someone has another option I didn’t consider. I think the biggest thing is getting people to weigh all of their choices before making a decision.
      Ben recently posted..How to Choose a Financial Advisor

      • For the short version, I’d have to say you need to do the analysis to see what would happen to your effective tax rate.

        I just finished the examination of my own situation and at a 401K contribution rate of 4%, my effective tax was 3.26%, however with a 401K contribution rate of 16% (which hits very slightly below the maximum allowed to be deductible), my effective tax rate was a very low 1.52%. I did that using TurboTax, and simply modifying my W-2 in a separate file from what I filed with the IRS to perform the what-if analysis, by lowering the 401K contributions (Box 12 of the W-2) and increasing the taxable income (Box 1 of the W-2) by the amount that I reduced Box 12 of the W-2.

        While that’s 53.37% reduction in overall taxes, I believe that the 1.74% rate reduction pales in comparison to paying 0% when I get to retirement.

        Especially if I hit my target of $750k in Roth account and plan on withdrawing 4% or more each and every year in retirement.

        Caveat: I will be performing this same analysis as our oldest 2 deductions (well our oldest children) approach the age limit for the Child Tax Credit.
        Chris recently posted..Choosing a Roth IRA or 401k for investment purposes

        • Wow, that’s a great, detailed analysis. One other thing to consider would be if you still plan on making any income in retirement the Roth will come in handy. You can balance out the income tax payments by taking Roth distributions free from taxes. Also, younger investors will see a higher value in the 401(k) tax break because they will be at a lower salary than later in their career. Tons of variables here, which is why I think it makes sense to have a little of both for diversification purposes.
          Ben recently posted..How to Choose a Financial Advisor

          • Absolutely Ben. Even in retirement one could put up to certain limits if they have the income, up to I believe age 70 (although I’m not 100% sure of that age).
            Other potential benefits are using the Roth to help fund a child’s education (and therefore making it potentially easier for a FAFSA loan to extend the payback if the student loan rate is low enough).
            The only time I foresee a reason to not get a Roth is when your tax rate is higher, or there is a much larger real value difference between the 2 rates (401k / Roth).
            Chris recently posted..Choosing a Roth IRA or 401k for investment purposes Part 2

  • [...] Tale of the tape: 401(k) vs. Roth IRA (Life and My Finances) [...]

Leave a Reply

  

  

  

You can use these HTML tags

<a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

CommentLuv badge