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

by Hank Coleman

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:

 

401k Retirement Plan

Roth IRA

Contribution Limit  $16,500 per year $5,000 per year
Minimum Age to Begin Withdraw  59 ½ years-old No Minimum Age
Age for Mandatory Withdraws  70 ½ years-old Never
Taxed When?  When Withdrawn Before Invested
Leaving Your Employer?  Contributions must stop Contributions can continue

 

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.

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{ 6 comments… read them below or add one }

Roth IRA vs. 401k Retirement Plan - Which Is Better? · Mutual-Fund-Investing.ExplainedOnline.Net July 8, 2009 at 6:19 am

[...] Original post by Own The Dollar [...]
Sorry, forgot to add great post! Can’t wait to see your next post!

Britt (Your Roth IRA) September 8, 2009 at 3:33 pm

Great post on the Roth IRA vs. 401k…

Here’s another difference. Most employer-sponsored 401k plans limit your investment options. For instance, the company might limit your stock market exposure to 2 or 3 mutual fund choices. Oftentimes, these funds have higher expense ratios than you might obtain if you purchased a low-cost index fund on your own.

But a Roth IRA? You direct the investments. It’s your choice. Even if your choice is to have a financial advisor handle things for you.

I think this flexibility is an added benefit with the Roth IRA.

Roth is better September 13, 2009 at 1:27 am

Roth is better because there is a good chance that taxes wil increase in future, so better to save your dollars into a tax free account.

George April 13, 2010 at 12:07 pm

In regards to Roth vs. 401(k) and in your example of putting $1000 into a 401(k) for 2o years, I’m having difficulty understanding why that income will be taxed at 38% in retirement. It seems to me that once I retire I’ll drop into a lower tax bracket (no earned income) and that money will be taxed at my marginal income tax rate then, which should be well below my working years tax bracket of 38% in the example.

Also, during that 20 year period isn’t that money being tax deferred? Isn’t tax deferral in and of itself an oftern overlooked hidden value? If so, how does that affect the calculation?

Hank April 15, 2010 at 10:22 am

@ George – Great question! You may or may not be in a higher tax bracket when you retire. I like to think that I will be earning more money or as much money in retirement and will be in a higher tax bracket or the same one at the very least. If that is the case, then a Roth IRA where your principle, interest, dividends, and capital gains will grow tax free may be a better option than a 401-k (assuming no match).

Your retirement pension, annuity payments, and interest earned on your retirement nest egg will all be taxed. Even Social Security benefits are often taxed at a small rate in some cases. In most cases, you will still have a tax liability in your retirement years. Depending on the size of your nest egg and its income stream, you may have a larger or same tax rate (marginal or otherwise) as during your working years.

Another factor that people often overlook is that tax rates may increase in the future. If that is the case, then it may be better to pay taxes now in a lower bracket with the intention being in a higher tax bracket thanks to our wonderful government’s meddling with tax rates in the future.

I am actually reading a very interesting book that I am going to review here on the blog in a few weeks, “Your Money Ratios”, by Charles Farrell who makes the claim that both retirement investment vehicles’ tax benefits wash each other out. It is six in one hand, and half dozen in the other.

Note – Don’t forget that 401-k’s should be used first if there is an employer match to your contribution. It is free money, and a 100% return on that amount of money.

Rick Hope May 13, 2010 at 6:18 pm

Hank,
I noticed a couple of things left out of your article. Isn’t there a 5 year minimum holding period as well as the age 591/2 rule?
I inserted the language below from ther IRS website.
A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
The payment or distribution is:
Made on or after the date you reach age 59½,
Also, don’t fortgot there is now a Roth 401(k) available and 401(k)’s have a loan provision. There i no borrowing out of any IRA. You are covered under ERISA for your 401(k), that means creditor protected.

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