401k Versus Roth IRA

First, let me clarify something regarding this issue.  What we are really talking about here is an “apples to oranges” comparison.  There are a few similarities, however.  These likenesses include:

• Both a 401k and a Roth IRA are considered retirement accounts.
• You can begin to take funds out of either account without penalty at the age of 59½.
• Assets grow tax deferred within these accounts.
  

After that, the similarities pretty much end.  The deeper we look, the more differences we find.

Most Americans have the option to participate in either of these accounts, but not both.  Not because the law won’t allow it.  It will.

However, the everyday employee has a limited amount of money to be socking away into retirement accounts. 

So, we want to get it right.  We want to be sure that those precious dollars being added to retirement accounts fit each of our unique needs. 

How does one know?  Let’s start with a series of questions, with the answers predicated on the fact that you are choosing between these two types of accounts.  The most important question first, with the idea of eventually eliminating one of these options and settling the question…..Which is better for me?  A 401k versus Roth IRA.

First Question

Does your employer offer a match?  If so, then take it.  You’re not going to get a match with your Roth IRA, so take advantage of your 401k match.  This is by far the most important factor in determining which retirement account is better for you.      

Think about it.  If your employer offers a “dollar for dollar” match, you have the chance to double your money with every contribution.  This benefit alone cannot be overcome by all of the benefits that a Roth IRA offers. 

If your company offers a match, you’re done.  Take the match.  That was easy, huh?

If not, let’s proceed to the second factor.

Second Question

Are you paying a lot of tax currently?  To know which account type will give you more net tax benefit, we need to know a little more about your particular situation.  One actually needs to know your Federal tax rate now, and in the future (which is as close to impossible as something gets).

That said, if you believe your tax rate is higher than it will be when you retire, then a 401k may make more sense. 

Roth accounts do not allow for current tax deductions, but they do allow for tax free withdrawal upon your qualified retirement.  So, if you suspect your need for a tax break is greater today than at retirement, take the 401k.  Conversely, if you think you’ll need the tax-free withdrawals at retirement, instead of tax deductions today, and you do not get a 401k match described above, choose the Roth.

Third Question

Do you need a larger deduction than what the Roth IRA offers?

Roth IRA contribution limits for 2011 are $5,000 unless you are at least 50 years old.  If you are age 50 and over, then you are allowed a total of $6,000 per year. 

401k maximum contributions for 2011 are set at $16,500, and $17,000 for 2012.  If you are 50 years old or older, that number jumps to $22,000 for 2011 and $22,500 for 2012.

For those over 50 years old, the maximum contribution difference between a Roth IRA and a 401k is substantial then.  If contributions beyond what the Roth IRA allows are important to you, my advice is to take the 401k.

For almost every other issue that I can think of, a Roth IRA works better.   Here is a listing of other factors that weight in favor of a Roth IRA.

• More Investment Choices.  Typically, a 401k plan offers limited investment choices whereas a Roth IRA will give you the universe from which to choose. 
• Lower costs.  Generally, a 401k will have plan fees either explicitly stated or buried within the plan.  These fees you generally can’t do a great deal about.  On the flip side, there are no retirement plan administration fees to pay for a Roth IRA account.
• Required Minimum Distributions.  At the age of 70½, you will be required to take distributions from your 401k.  The IRS currently does not require distributions from a Roth IRA at any age.

To summarize, when considering a 401k versus a Roth IRA, take the employer-sponsored 401k if:

• You get a company match or,
• Your need for a tax deduction now outweighs your need for tax-free withdrawals at retirement or,
• You need to be able to contribute more than what a Roth IRA allows for.  Remember, Roth IRA maximum contributions are less than half of that of a traditional 401k.
  

For all others, go with the Roth IRA.

 

401kFundAdvice can assist with 401k advice, IRA advice, and Roth IRA advice.