Making Plans and Achieving Goals

401K vs Roth IRA – The Ultimate Showdown

When it comes to saving for retirement, the two biggest investment options for your money are a 401K or a Roth IRA.  As with all things, they both have advantages and disadvantages.

First, some definitions:

A 401K is a retirement account which is funded with pre tax dollars and taxes are not paid on your earnings until you start withdrawing the money.  The 401K is typically provided as an optional benefit from your employer and pre tax dollars are automatically drafted out of your pay check every pay period and then invested.  By using pre tax dollars, it lowers your tax burden for that particular year as your earned income will now appear less.

A Roth IRA is funded with after tax dollars but your gains are protected from taxes so when you withdraw the money down the road, you will not have to pay taxes.  The Roth IRA would be set up on your own through some brokerage firm like Fidelity, Scottrade, Mass Mutal, etc.  You would fund this account with a portion of your take home money every pay period.

So which one to pick???

Lets look a little deeper into the pros and cons of each option and see if we can come up with a strategy.

401K Roth IRA Winner
Tax Advantage Save on taxes now but pay taxes in the future Pay more in taxes now but pay no taxes in the future Draw – You can’t know.  If you think you will be in a lower tax bracket when you retire than 401K is the better pick if you think you will be in a higher tax bracket than you are now, then Roth IRA is the winner
Fund Selection Fund selection will be very limited. Perhaps 20-30 mutual funds and maybe some target date funds. This means you might get stuck with some poor performing funds and higher fees You are free to invest in almost anything.  Mutual funds, ETFs, Bond Funds, Individual stocks and commodities or just leave it as cash Roth IRA – You should be able to get better returns year over year through having options
Ease of Use Typically, as part of the new hire process, you are coached through setting up your 401k.  Most people will then pick a target date fund or just set their allocation as conservative, moderate or aggressive  You will have to set up a Roth IRA independently of your company which means researching brokerage firms, researching investments and you will have to rebalance your own portfolio.  You also have to be disciplined to contribute the after tax money 401K – Even though setting up a Roth IRA is fairly painless, it does take more self discipline to manage it and contribute to it. Something as painful as saving money for the future needs to be as painless and easy as possible to create
Contribution Limits (as of 2016) $18,000.00 $5,500 if under 50. $6,500 if over 50 401K
Income Limits $265,000.00 Upto Limit if Single and AGI less than $117,000

Upto Limit if Married and AGI less than$184,000

Withdraw Age After 59 1/2 After 59 1/2 Draw
Early Withdraw Penalties Taxes on all money plus 10% fee Taxes only on earnings plus 10% fee on earnings Roth IRA – Because you can withdraw the principle you’ve invested penalty free and tax free
Company Match Possible Not Possible 401K – Some companies will match all or a portion of your contributions into a 401K

So which one should you choose?  Well, as always, it depends.  If you are above the income limits for the Roth IRA, then clearly you are looking at a 401K.  If you work for a company that doesn’t offer a 401K, you are looking at a Roth IRA.

Now for the rest of you who are eligible for both, my advice would be to invest in both of them.  “What!?  Why did we go through all this if in the end you weren’t even going to pick one?”  Well, every situation is different, but here is my logic which probably applies to a lot of you.  If your company offers company match, you should take the free money in the 401K.  If you think there is a chance of retiring before 59 1/2, the Roth IRA will help because you can withdraw your principle.  If you don’t think $5,500 per year is enough to be saving for retirement (it probably isn’t), then you need the 401K.  If you think you will be in a higher tax bracket when you retire than you are now, (either because you are earning more on investments than your salary or the government increases them) then you should go with the Roth IRA.

A simplified example: Julia makes $50,000 per year and wants to invest $7,000 per year.  Her company offers 50% match on her first 6% that she contributes.  My advice would be to invest 6% of her annual pay ($3,000) into her 401K  then invest the remaining $4,000 into a Roth IRA.

If Julia’s company didn’t offer company match, my advice would be to invest $5,500 into her Roth IRA account and then $1500 into her 401K.

So the good news is, you really can’t go wrong unless you do nothing.  Start now!  You don’t have to have it all figured out before you start saving for retirement, you just need to get started and always pay the “future you” first, with every paycheck.  Don’t wait until the end of the month or year to decide how much to invest based on what is leftover. You deserve more than that.


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