Given the choice, should you contribute to a 401k or Roth IRA? Which is the best IRA investment choice? If the Roth is as good as everyone says it is, should you consider converting your 401k to a Roth or Roth 401k?
To make a good decision, you have to have a basic understanding of taxes and investments. But it’s not complicated.
With the 401k, your contributions are deducted from your income so you get an immediate tax savings. Immediate tax savings equates to saving money for retirement. A good thing. Also, you can contribute up to $16,500 (2010), which is nice. And if you are over 50, your contribution limit goes up to $22,000. Finally, with your 401k, your employer might match some of the money you put in with a few of her own shekels. That’s good. Pretty…pretty…good.
The only downside to a 401k is that you have limited investment choices. OK.
The Roth IRA has different benefits. While you don’t get an immediate tax deduction, your money grows tax-free and, in most cases, you can withdraw your money – even the interest and gains – tax-free. That’s pretty sweet too. Your contribution limit is $5,000 unless you are over 50 years old, in which case it’s $6,000.
There are some limits though. If your income is $105,000 (for single taxpayers) or $167,000 (married taxpayers), the amount you can deposit into a Roth IRA gets phased out. While you’re alive, you never have to take any money out of your Roth, so you can keep piling on those tax savings and you can withdraw the money you put in anytime without a penalty. And of course, one of the greatest benefits is that you have complete control over how to invest the money, with unlimited choices.
Who should jump on the 401k?
If you can afford to put a lot of money away (more than $5,000) and/or if your employer offers a plan that matches your contributions, you should participate in the 401k. Here’s why:
1. The return is fantastic.
Even if the funds make “ka ka,” if you put in $1,000 and your employer matches that with $250, you just made 25% on your money. That’s spicy! It’s a great return with absolutely no risk so take advantage of it.
2. Tax deferral is a good thing.
There have been many arguments about this subject. I have a headache, so I’m not going to join in right now. I’ve written about this plenty of times before. Generally speaking, I like having a tax break today (via the 401k) rather than a promise of tax-free growth from now on. I have no idea what the government is going to do. I do know that they are in the business of changing laws and I don’t know if it makes sense to count on the tax-free status of the Roth staying as is. I’m the kind of Pilgrim who likes a turkey in the hand versus one in the bush.
You may have more faith than I do. This is not a clear-cut issue. And believe it or not, the differences are not always that great (depending on what happens with income taxes and whether or not you’re going to use your retirement money to pay for your retirement).
If you don’t think you’ll need the money in your retirement account but plan on passing it on to your kids, the Roth becomes more attractive. If you earn $100,000 and are in the 30% tax bracket, and you add $20,000 to a 401k, you’ll save $6,000 in taxes that year. That’s a lot of cabbage. The higher the income tax bracket you’re in, the more the 401k works. So if you’re in a high tax bracket and/or you can contribute more than $5,000, the 401k is the first place to put retirement money.
Finally, I like the 401k because it’s hard to access. The less money you spend today results in having more money during your retirement. Do you know why most of my clients have most of their liquid money in retirement accounts? It’s because they can’t spend it. It’s expensive to get to, so they tend to accumulate it.
Why would you go with the Roth IRA?
There are a few scenarios where the Roth IRA is more attractive than the 401k account.
First, if your 401k investment options absolutely stink and you wouldn’t participate in that plan no matter what, the Roth might be the only choice available.
Second, if you are in a low tax bracket now and plan on hitting it big in retirement, the Roth will be a good choice (if you believe that the tax free withdrawal rules will still be around at that time).
If you want to hedge your bets, you can usually take advantage of both options (so long as you don’t violate the income IRA restrictions mentioned above for the Roth IRA). I’d invest in the 401k first to get the company match and keep contributing the maximum to slash my income tax bracket as low as possible. Then, once I did that, I’d throw money into the Roth.
The great thing about comparing these two accounts is that if you can’t decide which one to use, you can legally participate in both. Just make sure you meet the income limitations of the Roth. A common strategy that people use when deciding how to allocate retirement funds is this:
1. Invest in your 401k to get your company match.
2. Invest in a Roth IRA to the max.
3. Come back to the 401k and finish maxing it out.
That’s what I would call overall tax diversification in your retirement savings plan. What’s your take on this? Where do you put your retirement money?
photo by WoodleyWonderWorks, Flikr
Ronald Dodge says
Oh yeah, I also failed to mention the other reason to have ROTH IRAs is the fact ROTH IRAs don’t force you to follow the RMD rules as does all other retirement accounts within the USA. The RMD rules is the perfect formula to outlive your money, and that’s another reason why I prefer ROTH IRAs over any other retirement account.
As for the author’s statement about withdrawing at any time without penalty from a ROTH IRA, that is simiply not true. First, you must have the account open for a minimal of 5 years before you can withdraw any money from it. Then you must either be 59.5 years old or you must meet one of the exceptions to the rules to be able to withdraw from it without getting that 10% penalty charge.
I would highly discourage from withdrawing from such account, but if you have no realistic choice to withdraw from it, then you don’t have that realistic choice. You however must think long and hard about this as you can’t put it all back in keeping in mind of contribution limits and you lose out on the power of compounding interest not to mention about potential penalties and higher tax rates.
As such, for the emergencies, I would highly recommend setting up an emergency fund so as you don’t have to take such measures. Now once you do that along with the retirement account(s), you must strike a balance between how much to put into retirement funds (matching policy and retirement saver credit may play an impact on that), how much to put into an emergency fund (your current life situation will play an impact into this), and debt reduction (how bad off are you if you are buried in debt may end up taking presidence, which means you may end up taking on a much greater risk for going this route given you may be forced to take out more debt for when an emergency does come up).
Neal@Wealth Pilgrim says
Ronald, FYI – I didn’t say you can withdraw $ from the Roth anytime.
Ronald Dodge says
First, max out the matching policy.
Second, max out ROTH IRA(s), if allowed by law.
Third, max out 401(k) plan
Why that order?
First, the 401(k) plan has been trending a laggard by 2% over the years as compared to their respective benchmarks in the market. As such, while the rate of return for the matching is good, eventually as the account gets large enough, the fees of such accounts will outstrip the benefits of the matching policy. Therefore, by putting in up to just enough to max out the matching policy will help keep the account low enough in many cases to where the fees won’t necessarily outstrip the matching policy of the account.
Second step is to max out ROTH IRAs as allowed by law. First, given I’m in a low income tax bracket, and I’m expecting to be in a high tax income bracket when I am in retirement, this only makes sense to go that way from an Accounting point of view.
Second, I avoid many of the fees that are in the 401(k) plan and actually, my investments in the ROTH IRAs and Taxable Accounts both been trending about 1% to 2% higher than their respective market benchmarks. This year, it’s working out to be an exception for all of my investments with the sole exception being the 401(k) plan as that’s still going along with the same basic trend. This year, my investments as of the end of yesterday (Nov 30), they have increased by 28% on the average thus far when excluding the 401(k) plan from the mix. Now rather if that’s me doing something right or if it was just the luck of the draw, only time will tell.
As for the third step, maxing out the 401(k) plan, I still don’t really like this idea in many respects given how much of a laggard the set of funds been in it as compared to their respective benchmarks. As such, I think of this 2% trend as management fees taken out of the funds via the 12b fees by hiding the fees via lowering the NAV (aka share price) on funds. On the other hand, if the market moves up 7% and thus the account moves up 5% on the average, it still may make more sense to invest in it than into annually taxable investment accounts given the fact the annual taxes weighs rather heavily on the investments over time. But then so does this 2% laggard rate as it weighing heavily on the investments in the 401(k) plan.