Roth IRA vs 401(k)

The debate between which of these two great retirement accounts is better has been going on as long as they have both been around.  My thinking is that one is not better than the other.  Individually, each is worse than they would be together.  Bear with me for a moment, before you call me crazy.  I am going somewhere.  Let’s try it this way – with numbers. 

I’m going to take one initial $5,000 investment and show you how powerful a combination of accounts can be.   In this example, you are currently in the 25% tax bracket, and you end up in the same bracket when you retire.

As you can see, both the Roth IRA and 401(k) end up with the same value at the end.  They always equal each other if your tax bracket remains the same.  But look over at the combo accounts – the ending value is more than $4,000 higher.  What happened, you ask?  Well, let’s see.  The Roth income is not taxed when you withdraw it, and it does not count as income.  The 401(k) is your only taxable income.  In the government’s eyes, your income is lower, so they toss you in a lower tax bracket – 15% in this example.  You have the same pre-tax money, of course -it’s just that you pay less taxes. 

My retirement advice remains that you should always contribute enough to your 401(k) to get the maximum match.  That’s free money, and no tax savings is going to make up for missing out on it.  But once you’ve hit that point, you need to open a Roth IRA and fund it as much as you can.  Your goal, if your income provides, should be for a rough 50/50 split between the two accounts.  That will put you in the best situation from a tax standpoint.  Paying less taxes means that you end up with more money in your pocket.  That’s good news anytime – but in retirement, it’s even more important.

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Starting at age 26

If you start investing at the ripe young age of 26 ( that’s how old I’ll be in a few months ), then you have 34 long years to enjoy the magic of compound interest. Assuming you earn an average return of 10% per year ( shouldn’t be difficult if you stick with low-cost index funds ), then you must save $308,700 per month until age 60. At that point you will have just over $1 billion in your brokerage account.

Starting at age 35

If you putt off your grand investment plans until age 35 ( or if you’re already at that age ) things don’t look quite as rosy. To reach your $1 billion goal by age 60, you’ll need to sock away $693,900 every month. That’s over double the amount required if you start at 26 – that’s the power of compound interest.

What can you do?

Not everyone can afford to invest $693,900 per month – and that’s why you need to start early. If you start at 26, your monthly investment is much more reasonable. If you cut back in a few areas, I don’t see any reason why you can’t invest a measly $308,700 each and every month in your brokerage account.

That’s a little much

Ok, ok, perhaps not everyone can come up with $308,700 to invest monthly. If you can manage $280 per month in the same investment, you’ll still wind up with a cool million bucks. While they won’t carry you through retirement, it’s not a bad start. Oh, and the clock’s ticking.

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•  Mystery Match. There’s an employer match, but no one has any idea how much that match is. The HR director doesn’t even know.
• Long vesting period. I have to stay employed here for a total of 5 years to become fully vested in the company mystery match and it’s earnings. If I leave before then, I lose out on that money.

Granted, I plan on staying put in my current job.  However, there’s no telling what the future will hold. I’d hate to lose out on a sizable chunk of cash because a better opportunity came along.  That coupled with the mystery match make my 401(k) less than stellar.  At least there are a few solid funds to choose from.  ( A few more choices wouldn’t hurt my feelings though. )

Well, that’s my lame 401(k) – how bad / good is yours?

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• After-tax contributions.  You don’t get a tax break in the current year, but your withdrawals will be tax free ( as long as you’re at least 59 1/2 )
• Forced withdrawals beginning at age 70.  Like the 401(k), you’ll have to start taking money out of your Roth 401(k) once you hit the ripe young age of 70.
• $15,500 yearly contribution limit.  Between your regular 401(k) and your Roth 401(k), $15,500 is your yearly limit.
• Employer matches go into your regular 401(k).  Weird, but your employer match doesn’t go into your Roth 401(k), but rather your regular one.
• No income limits.  Unlike the regular Roth IRA, anyone can contribute.
• Non-retirement age withdrawals are weird.  Say your account consists of $8,000 in contributions and $2,000 in earnings ( or 80% and 20% ), for a total of $10,000.  You want to pull out $2,000 for an emergency medical bill ( and you’re not of retirement age ).  Since your account consists of 80% contributions and 20% earnings, 80% of your withdrawal is not taxed, while the remaining 20% is taxed.  So you won’t pay taxes on $1600 of your withdrawal, but you will pay taxes on the remaining $400.  There is also the usual 10% penalty to add insult to injury.  In other words, don’t withdraw your money early!

Sounds like a pretty good setup.  You lose the withdrawal flexibility that the regular Roth IRA offers, but you get the benefits of non-taxed retirement withdrawals.  Unfortunately, my employer doesn’t offer the Roth 401 (k) – they only offer a lame 401(k) with a mystery match and 5 year vesting period.  Does your employer offer a Roth 401(k)?  If they do, are you contributing?

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401(k)

• Money is deducted from your paycheck automatically – if you don’t see it, you don’t miss it
• Your contributions are tax deductible for the current tax year
• There’s a big penalty for early withdrawals ( it’s for your retirement, after all )

Roth IRA

• Your entire withdrawals are tax free ( contributions and earnings ) once you are of age
• You can withdrawal your contributions at any time, without penalty

With the Roth IRA, you don’t get an upfront tax break like you do with a 401(k).  To offset that, your withdrawals are tax free ( after age 59 1/2, of course ).  If you think you might be in a higher tax bracket during your retirement days, then a Roth IRA is a fantastic idea.  Since taxes are ( believe it or not ) extremely low in the US these days, there’s a good chance your tax rate will be higher when it’s retirement time. 

The other big thing I really like about the Roth is the flexibility.  If I need the cash for whatever reason, I don’t have to pay any silly penalties to get to it.  It’s my money after all – and I’ve already paid taxes on it.  On the flip side, you really shouldn’t make any early withdrawals if you can help it.  Your retirement is extremely important, and compound interest is what makes it possible.

If you don’t have a Roth IRA yet, you need to, have to, must get one right now.  You can open one online with nearly every major financial institution.  I’m currently using USAA, since my wife is prior military.  I hear Vanguard is great as well.  No matter what, it’s important that you get started now, rather than later.

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1. 401(K) with an employer match: Even if your employer has a weak match ( .25 on the dollar up to 5% ), always contribute as much as needed to get the maximum match. Even at a quarter on the dollar, that’s a 25% return, in addition to the earnings on your investment. This is free money, and there’s no reason not to take every penny of it.
2. Roth IRA: You Roth contributions go in after tax, so you don’t get the fancy tax deduction. But your retirement-age withdrawals are tax free – contributions and earnings. And one of the really neat things about a Roth is that you can take out your contributions at any time, without penalty. You shouldn’t, of course, but I like the fact that you have the choice.
3. 401(k) without employer match: If your employer isn’t as generous as some, you might not get a 401(k) company match. But you should still sock some money away here, since you do get the current-year tax deduction. Withdrawals are taxed, of course, but tax-deferred is better than nothing at all.
4. Taxable investments: Regular index funds, mutual funds, stocks, bonds, etc go here. These are important, of course, but don’t offer the tax advantages of the first 3 accounts. Only play around in this area once you’re contributing enough in the first three programs.

By investing your money in this manner, you’re likely to come out ahead when it’s finally time to hang up your shirt and tie, and retire. The most important rule is this – Maximize the Match. Recite it, repeat it, and remember it. Even a weak match ( .25 on the dollar ) is a guaranteed 25% return on your money, even if your investments stay completely flat. That type of guarantee doesn’t exist anywhere else. Use it, maximize it, and profit from it. No one wants to be broke when they’re retired. Investing your money smartly will help keep that from happening.

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