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What's better? 401(k) or Roth IRA?

Posted by PeyWorth on 4/23/2011 at 5:04 PM | 33 answers | 1253 views
I think it's safe to say most financial planners would agree maxing out a Roth IRA is a better strategy for building long term wealth than contributing to a 401(k). I don't quite understand why this is so...

I see the advantages of both, but it seems to me there would be some benefit to allowing your pretaxed 401(k) investment to compound for long periods of time before withdrawing. Wouldn't that extra 25% to 30% of contributions really help to propel net worth in the long run?

Conversely, I can also see the benefit of a Roth IRA since all the dividends and growth will not be taxed in the future. All the compounding growth is yours to keep.

Also, would age be a significant factor? Maybe younger investors could benefit more from a Roth IRA since there is more time for compounding and no tax burden in the future?

Any ideas or help on this topic would be appreciated. As a 28 year old, the answer to this question could really make a difference in my retirement balance in 35 years.

Answers

401k = $16,500 max + employer match before tax annually
Roth IRA = $5000 max after tax

Which do you think would enable you to build more long-term wealth?

"Wouldn't that extra 25% to 30% of contributions really help to propel net worth in the long run?"

It's pretty much a wash from that perspective - because although you have an extra 25% to 30% to contribute (assuming equal gross contributions) in the (traditional non-Roth) 401k you have to pay taxes on all distributions, on the Roth you pay no taxes at the time of distribution.

"Also, would age be a significant factor? Maybe younger investors could benefit more from a Roth IRA since there is more time for compounding and no tax burden in the future?"

Argument is no different from 401k scenario.

As with any investment where you are looking for compounding to help you over the long term, the best approach is to contribute as much as you can early on. There is no disputing, with a 401k your ability to contribute larger amounts is enhanced. With my employer match, I get $20,500 a year going in to my 401k, and then in the stable value fund I get my interest compounding - which is generally 5% a year on average. That 5% a year is some pretty significant money for me at this point - because I've been maxing out the 401k all along.
Hi njhowie,

I really appreciate your input. Here's a couple questions I have based on your response:

You mentioned the difference in account balances between a 401(k) and a Roth IRA pretty much come out to be a wash. How could this be, though, since one is taxed prior to compounding and growth and one is taxed after? Is it possible the growth of a Roth IRA and the taxation of a 401(k) are, more or less, the same despite the issue of dividend growth and compounding?

Also, I agree if you contributed $16,500 each year into a 401(k), you'd have more money upon retirement than contributing $5000 each year into a Roth IRA; however, I'd be very interested to see the answer to this question:

Which scenario would produce more money assuming the rate of return was exactly the same?

Placing $5000 of taxed earnings in a Roth IRA account and letting it ride for 40 years or placing $6500 ($5000 x 1.30 for taxes) in a 401(k) and letting it ride for 40 years - taking into account taxes upon drawing this money out on retirement.

I would be very interested to see the answer to this question.
"Which scenario would produce more money assuming the rate of return was exactly the same?

Placing $5000 of taxed earnings in a Roth IRA account and letting it ride for 40 years or placing $6500 ($5000 x 1.30 for taxes) in a 401(k) and letting it ride for 40 years - taking into account taxes upon drawing this money out on retirement."


I have actually run the numbers on this scenario, because I am skeptical about a Roth being "better" than a 401(k). It turns out that if the tax percentages are exactly the same today as they are at retirement then there is absolutly no difference after you take out the taxes of the 401k.

But when you are in your 20s, your income should be very low compared to how much income you will have in your retirement age if you continue to save your money.

The other advantage to Roth IRA is if the federal tax skyrockets when you retire, you will be able to withdraw your Roth money tax free.

Personally, I believe if you save enough money (in either or both type of account) you will have so much money you won't care, because you will have millions. :)
Hey mdv1984,

Thanks for the information. Today I ran a similar scenario and I essentially came out with the same result. It got me thinking about which one is better. I'm also not completely convinced the Roth IRA has that much utility over the 401(k) so until somebody gives me a really compelling reason why either is better, I'm still maxing out the Roth IRA and contributing as much as I can to my other retirement accounts.
I believe the preference for the IRA over a 401K comes from the fact that many 401K plans only offered a limited number of high expense ratio funds.

Unless my calculations are wrong, if you are maxing out all of your tax advantaged space, contributing with post tax dollars is almost always a win. If you don't have any saving in taxable accounts it's pretty much a wash if you stay in the same tax bracket into retirement.
At the time 401k was conceived, it was based on the assumption that when you retire, your earnings (and therefore taxes) would be lower than your mid/peak earning years and therefore the benefit. Seeing the way the world has changed over the years and the uncertainty around taxes, it's no longer cut and dry.
I agree with njhowie regarding future taxes. I would make sure to contribute to your 401K at least until you get the full match. You don't want to leave any free money on the table. After that, I would max out the Roth IRA. If you still have extra money after maxing out the roth, continue saving in the 401K.
Great recommendations.

It goes without saying taking advantage of the employer match is a must. My employer does not match so I've opted to max out the Roth IRA then contribute as much as I can to my 401(k).

I'll certainly take the tax issue under full consideration.
If no match, definitely the Roth at your current income. If you made $250k, your tax bill is so much greater, therefore the advantage of the 401k to lower your tax bill.

Also, assuming you will eventually make too much for the Roth eligibility, you need to get in while you can. There also is no guarantee that this option will be there in the future.

Then when you start to withdraw various funds, you can use taxable accounts and Roth's to control your draw-down of your deferred accounts, therefore controlling your own tax destiny (unless laws change radically in the future).

We max out our 401k's as we make too much for either IRA's & their benefits, but that's a good problem to have (I have to keep repeating that to make it true).
surewhitey - There is currently a loophole for folks in our income bracket to get into Roth IRA'a. You can make a "non-deductible" traditional IRA contribution, then immediately convert that money to a Roth. In 2010, the income limit on conversions from Traditional to Roth's expired. Also, this is not a taxable event because the contribution you make is "non-deductible". My wife and I have been able to get $20K into Roth's over the past 2 years. Congress may repeal this at some point in the near future, so you may want to take advantage.
Sorry, I meant as of 2009.
Roth IRA is superior in every possible way to a 401(k), assuming tax rate neutrality and competence on the part of the investor. The obvious caveat being one must always contribute enough to capture a match (unless the plan itself is horribly designed).

The better question is whether a traditional 401(k) or a Roth 401(k) is superior. Perhaps we can get a discussion going around that.
M543 - in some states 401(k)'s have greater bankruptcy protection, otherwise if the investment choices are decent I'd say its a wash if you qualify for both.

I am maxing a roth 401(k) and converted all my old IRA's in 2010. I have not been making current contributions to the IRA for the time being. Once I pay off the house I intend to start doing that again, although I have to fund a non-deductible IRA and then convert it due to my income levels. If my stock grants track right that should be in the next 3-4 years.

The other notable fact is that if you get a match on Roth 401(k) funding, it will be tax deferred money not tax free. This is because there is no current taxation on the match.

I am very pro-roth (for my personal circumstances). I think I am about the only person on this site who reduces their net worth for the deferred taxes on my traditional 401(k) balances.

Ramrod - that loophole only works if the person has no other IRA's, otherwise they would either have to allocate the basis from the non-deductible monies or convert all the IRA's.
I am also very pro-Roth due to personal circumstances.

But there is definitely not a one-size-fits-all answer on this one. There are so many individual variables to take into consideration.

I do think it is important at some point in retirement planning to consider the impact of Required Minimum Distributions (RMDs) from 401Ks and traditional IRAs. There was a great thread over at bogleheads addressing how some retirees are shocked at how high these can get over time. A good problem to have, but it helps to see it coming!
Traditional 401k vs. Roth 401k - if the outcome is going to essentially be the same from a dollar perspective, whose pocket would I rather see the money sitting in for the next 25 years mine or Uncle Sam's? If Uncle Sam has the money (taxes) today, he will squander it away. If it is sitting in my pocket, well then I have more money to invest/work with and Uncle Sam will be taking on a portion of that risk. If I lose money in my 401k, so too will Uncle Sam.

Roth primarily exists because Uncle Sam wants your tax dollars today.
howie,

If you're at the contribution limits for your tax-deferred investments and trying to put more away tax-preferred, would you first switch some of your 401(k) to Roth, or invest in an open account?

As stated previously, I've been intending to max our retirement contributions (first step is rebuilding cash, which is almost done). As I look at our options, we're close to no longer qualifying for Roth IRAs, so it looks like 401(k), Simple IRAa and Roth for any amount we still qualify for. We're likely to still have additional money we'll want to save after hitting those annual limits, so one approach I'm considering is making part of our 401(k) Roth, which will leave us with a larger amount of savings since it will all be after tax money.

We already have my wife's rollover IRA which is traditional and all of my 401(k) to this point is traditional. And due to a generous company plan, we receive 7.2% in fixed and matching contributions (and the performance part was an additional 4.08% this year), so annually we're likely to see 10-12% of pay contributed to the 401(k) on a traditional pre-tax basis as long as I work here.

So in this instance my plan is once we're at our cash goal to first max the 401(k), then in 2012 or 2013 to start changing our contributions from traditional to Roth. Any arguments you have against that plan?

The pros for me: 1) Increase my effective contribution limit
2) improve my tax diversification to hedge against future rate increases
3) Roth plus traditional allows a more tax efficient withdrawal strategy than either Roth alone or traditional alone
4) Reduce the amount of money subject to RMD

Anyone want to provide a list of cons?
Slipped my mind, but if we don't qualify for Roth, the non-deductible traditional IRA is available. So we'll put in 10K in after tax IRA money one way or the other. Shouldn't change the question.
Put $10K in the non-deductible traditional IRA, then immediately convert those contributions into a Roth. There is currently no income restriction on Roth conversions. Money will grow tax free and you will be able to withdraw it tax free at 59 & 1/2. Who knows how long this lasts, so you may as well take advantage now. The way things are going, tax rates are likely to be higher in the future.
Thanks ramrod.

I have to be honest...I kind of knew this, but I've been too lazy to do anything about it. Shame on me.
ramrod and surewhitey:

If you currently have money in traditional IRAs, converting to a Roth is not always the best move. While you can still make the conversion, you have to include all traditional IRA's (both deductible and non-deductible) in the aggregate calculation to determine the amount to be taxed. In other words, you cannot just select to convert your most recent IRA's, you have to take your previous ones into account.
M543 --

If your wife self employed you could look into setting up a solo Roth 401k. We may be looking into that option as my husband is contemplating accepting some interesting contract work.
Cheers,

I think they're talking about those who don't qualify for a Roth IRA contribution making a contribution to a traditional non-deductible IRA and then converting it. There's no tax cost to doing so since there was no tax benefit in putting the money in. I hadn't paid much attention to this provision, but will have to consider it this year. It will eventually go away.

As for the solo Roth 401(k), I'll look at the rules on that. Thanks for the suggestion. I've taken a look at the options available for the self-employed and typically find myself looking to the Simple IRA, but will give the Roth 401 a hard look.
M543 --

I was just clarifying the rules for those who intend to make a conversion from a traditional to a Roth IRA. My husband and I did this last year when we made too much to directly contribute to Roths.

BUT, it is important for those who intend to utilize this conversion that they understand the possible implications. If the taxpayer already has traditional IRA accounts they cannot chose "which" funds to convert. When tax time comes it is the aggregate amount of all IRA funds in the taxpayers name that is utilized to calculate the tax bill.

That's why Congress allows the conversions for higher earners now. They are hoping to get taxes on the conversions, vs waiting for the RMDs.
Yep, I should read ALL the words.
LOL

Get in trouble often for "selective hearing?
M543,
For the self-employed 401k is usually too much hassle/cost. It is generally better to go with Keogh because the contribution limits are far greater than even 401k and you get the same tax deferral benefits.

http://www.tiaa-cref.org/public/products-services/retirement/small-business/keogh/index.html
PeyWorth,

I'm in a nearly indentical finanical as yourself (looks like you've got more cash congrats!). Lots of great advice above, not sure what more I can add. I've always contributed to my 401K up to my employers match (4% currently), if I don't at least equal the match I feel I'm leaving money on the table.

After that I contribute all cash towards a Roth. I use this as my main investment account as all gains will be tax-free (hopefully...).
First, 401k up to the amount the employer matches. This gives you a larger nest egg to start growing. Its like giving yourself a raise. However, your investment choices are limited to the 401k offerings.

Second, Roth. This allows you to have more choices where to invest. Also, after you reach age 59.5 (under current us law) you can pull the yearly growth out tax free and leave the principle. Use that yearly growth to pay debt, take vacations, etc. -- tax free.

Third, SEP IRA/Keogh this gives you tax deductible contributions and allows you to choose where you want to invest.

Fourth, back to the 401k non matched amount.
The reason the IRA and the Roth is a wash is because whatever you do, the money is taxed *once*, either before or after you earn on investments.

Say your money will double in 10 years, and you have 10k now, at a marginal tax rate of 25%. If you put it in an IRA, you'll have 10k now, 20k after the decade, and after you pay off uncle Sam, there's 15k. If you put it in a Roth, you'll pay uncle Sam now, leaving 7.5k, which doubles to 15k after the decade.

The very important assumption is that you will have the exact same tax rate now and after the decade. If you expect tax rates to be higher now than after your investing period (say, you're retiring and expect no other income) - take the IRA. If you expect tax rates to be higher later - pay the piper now with the Roth.

One thing I've heard a lot is that your tax rates will be lower, when you withdraw at retirement. That may well be true, but since we're not lunatic investors, your 35-year time frame means you WILL end up with FAR more money than your deferred salary.

Taking a very conservative 6%, Roth every year $1 for 35 years leaves you with $119.1. This almost 120x your annual contribution amount, you will withdraw during your retirement of say 20-30 years. Therefore, you will withdraw at LEAST 4x your contribution amount annually if you drain it.

If your contribution amount is somewhere around 25% of salary (definitely possible), then you will be taking more than your original salary out - and getting it taxed as if income. It is quite possible that due to over-compounding, you will pay higher taxes on 'too much' retirement income, not less.

Also, the Roth has much better rules on it. There are no required minimum distribution bull on it when you turn 70.5, and quite incredibly, it can be inherited and continue compounding tax-free beyond your lifetime. (if the beneficiary picks the equal payments over *their* projected lifetime option - force them)

With the new Roth 401k option, you can have all your monies (except employer match) in a Roth-like account from the get-go.

Lest I be one-sided, there's one way to extract more tax advantages from a traditional IRA (or regular 401k) - if you live in a high-tax state. If you take a deferral or deduction, you also wipe the amounts off your state income taxes. After you retire and withdraw the money, it's income - to your retirement home state. If that one has no/lower income tax... you've basically dodged getting your working state's paws on the money.
My final recommendation is to always get the full employer match, and place enough money in a 401k/IRA to expect to withdraw every year in retirement the same amount (include all taxable things like SS) as your post-deferral salary now (or up to your tax bracket max). The rest should be left in Roth-like accounts. It's complicated, but this should generate the maximum in-pocket money if you expect equal taxes now and then.

If you're making say 40k now (and blithely say you will for the rest of your career), and you wish to stick 10k into retirement accounts:

1. Get your full employer match, period. Say they'll hand you another 1k - this money must be in a regular 401k. You hence end up with 11k per year.

2. Get a projection of your investment returns over 35 years, and your retirement length. Say you'll get 6%pa and retire for 30 years. You will hence expect to retire with 1.31M (yes, a millionaire - the magic of compounding) before taxes, which has to last for 30 years.

3. You want your tax-deferred accounts to be drawn down at a rate of 30k a year (the same as if you worked at your job still and still deferred to retirement). If you draw down less, you had more income while working and presumably paid more taxes total; the reverse is similar.

4. At a 6% rate (it still grows while you are retiring), to have an account balance of 0 after 30 years of 30k withdrawals, you should start retirement with a 407k balance. Therefore you should put 407k/1.31M or 31%, or $3423 per year of your 11k into deferred accounts, and the rest in Roth-likes.

Just for fun, if you continue living on your 30k pre-tax income into retirement, you will never need to touch your Roth accounts, and after your retirement of 30 years, you will have a pre-tax networth of 5.18 million (you'd have paid tax on it already). 3+ million for you to throw around at a whim.
Of course, if you want to spend it all, you can retire for 30 years with an income of $96k, while paying tax (the same rate) as if you earned $30k... while not working, of course.
Excuse the multiple posting, but the numbers above are slightly off. Since you only deferred $3423 (and 1k of it is employer match), your taxable income while working is not 30k, it's actually 37.6k.

To get the 'exact' number (dependent on your 65-year assumptions of investment returns lol), you'd have to rerun the calculations to draw down 37.6k per year in taxable income, get a new number, and plug it back in to do it yet again, etc. It'll eventually settle into the real answer.

The difference should be about negligible, a couple hundred bucks more to 401k/IRAs at most.
M543, here are a couple of good articles regarding Traditional vs ROTH 401Ks:

http://thefinancebuff.com/case-against-roth-401k.html
http://thefinancebuff.com/roth-401k-for-people-who-contribute-max.html

I'm currently opting for traditional rather than ROTH 401k contributions by the way. If I didn't, my AGI would put me into the phase-out income limit for a ROTH IRA, and I also feel that the reasons stated in the articles above apply in my case.

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