Roth IRA vs. 401k Retirement Plan – Which Is Better?

Should American workers invest in a Roth IRA or their company’s 401k retirement plan? Both investing options are great choices to invest for retirement, but there are certain strategies for workers and their family to consider when investing. There are several fundamental differences between the two plans which point to where you might want to invest first. A Roth IRA allows investors to contribute “after tax” dollars to the investment and then withdraw the principle and earnings tax free during retirement. A 401(k) plan or public 403(b) plan is funded with “before tax” dollars and withdraws in retirement are then taxed at your normal income tax rate at that time.

There are many differences in the two plans, and you need to understand the intricacies to get the most out of your investments. Below is a list of the common features of both:

A lot of investors are in a low income tax bracket when they first graduate from college or high school and then usually move into a higher tax bracket towards the end of their careers and in retirement. Because 401k money is taxed when you withdraw it, you would then end up paying more in taxes using a 401k retirement plan rather than a Roth IRA in most scenarios. There is a distinct tax advantage to maxing out your contributions to a Roth IRA first, and then investing in a 401k plan with any additional savings after that.

For example, say you had only $1,000 to invest and are in the 25% tax bracket right now. Your one time investment of $1,000 will go straight into your 401k and then grow to a little over $4,600 in twenty years (8% growth per year). Then, you withdraw it to spend it during retirement and owe taxes on that $3,600 of profit and the original $1,000 investment as well. But, now you are in the 38% tax bracket twenty years into the future. So, you get to keep only $2,880 of your hard earned money after taxes. If you had invested that $1,000 twenty years ago in a Roth IRA, you would have had only $750 to invest after 25% was taken out right away for taxes. That one time investment of $750 would grow into $3,500 in those twenty years and can then be withdrawn completely tax free.

Now think of that $1,000 on a larger scale. If you maxed out a Roth IRA (currently $5,000 per year in 2009 if you are under the age of 50) from the time you were 22 until 65, you would have approximately $1.9 million nest egg tax free.

There is one last thing to think about with respect to 401k plans. If your company matches your contributions in your 401k plan up to a certain percentage, you should at least invest that amount from the very beginning.  For example, if your company contributes a match of up to the first 5% you put into your 401k plan, that is equivalent to a 100% return on that 5% of salary!!  You put in 5% and your company puts in another 5% for a total of 10%.  That’s a great deal!  You should always put the maximum your employer will match in your 401k retirement plan first or else you are just throwing away free money.

As of 2009, a person can put up to $5,000 in a Roth IRA or $10,000 in a joint fund if married.  To open a Roth IRA, an investor has to have earned an income and file taxes.  One down side (that might change soon) is high wage earners who earn over $120,000 a year or $176,000 if filing a joint tax return cannot currently contribute to a Roth IRA.  There are no income stipulations for 401k plan participants.  People over the age of 50 can invest an extra $1,000 as a catch-up payment for a total maximum investment of $6,000.  Investors over 50 years old can make an extra $5,000 deposit on their 401k plans per year as well.

Related posts:

1. Reader Question – “What Are The Consequences Of Rolling Over A 401k Into A Roth IRA?”
2. Understanding If Roth IRA Conversions Are Right For You In 2010
3. The First Questions You Should Ask Your Employer About Your Retirement Plan

Tagged as: Mutual Funds, Retirement, Roth IRA