Roth IRA or 401K - Which is Better?
Q: I am trying to decide if opening and contributing to a Roth
IRA would be a better option than contributing over and above
what my company matches in my 401K.
A: Ideally, it's best to max out both your 401K and Roth IRA
accounts; the more you can save for retirement the better.
However, for many people this is not possible, so the question
then becomes which account should I invest in first?
Generally, it's best to invest in your 401K plan first, up to
the amount your employer will match, then to invest in a Roth
IRA. If you have additional funds to invest after making the
maximum contribution to your Roth IRA, you should max out your
401K, and then invest in taxable accounts. There are always
exceptions, however, so here are some points to consider when
deciding the best order to invest your retirement funds:
Matching Contribution - many employers will provide a matching
contribution when you elect to participate in the company 401K
or other employer sponsored retirement plan. This is free money,
and should be taken advantage of even if your 401K plan isn't
the best due to poor investment choices, high expenses, etc.
There is no matching contribution for a Roth IRA, so you should
invest in your 401K up to the matching contribution first,
before you invest in a Roth IRA.
Investment Choices - Most 401K plans have a limited number of
investments to choose from. Roth IRAs can be opened just about
anywhere: mutual fund companies, brokerage firms, banks, etc.,
which means your investment choices are unlimited. If your 401K
plan has limited or poor investment selections to choose from,
the Roth IRA may be the better choice (after you contribute
enough to get the matching contribution in your 401K plan).
Taxes - although your 401K contributions are tax-deferred, which
allows more of your money to go to work for you, money invested
in a Roth IRA grows tax free. As long as you follow the rules,
you may never pay taxes on the earnings in a Roth IRA. If you
expect to be in a higher tax bracket when you retire, this could
result in substantial tax savings.
Because withdrawals from a 401K account are taxed at your
ordinary income tax rate, withdrawals could potentially push you
into a higher tax bracket. If you have a combination of 401K and
Roth IRA accounts, you have greater flexibility in choosing
which account to withdraw from, which could allow for tax
planning opportunities to help minimize your taxes during your
retirement years.
One more note regarding taxes: 401K, traditional IRAs, and other
employer sponsored retirement plans are subject to the Required
Minimum Distribution rules; Roth IRAs are not. Again, having
Roth IRAs in combination with your 401K accounts can provide tax
planning opportunities not available to people who only have
401K accounts.
Withdrawals - your contributions to a Roth IRA are available to
you penalty and tax-free at any time. Your earnings in a Roth
IRA may also be withdrawn at any time. There is a 10% penalty,
but this penalty may be waived under certain circumstances
(disabled, first time homebuyer, qualified higher education
expenses and more). Withdrawals from a 401K plan are much more
restricted, as employers may or may not allow early withdrawals
or loans.
Automatic investments - contributions to your 401K account are
automatic since they come directly from your paycheck. This
makes investing in your 401K easy and convenient, and after
you've started contributing, most likely you'll no longer miss
the money being invested. Investing in a Roth IRA takes more
effort. Although many Roth IRA custodians will allow you to
setup an automatic investment plan from your checking or savings
account, it takes more discipline to invest in a Roth IRA than
it does to invest in a 401K plan. If you think you don't have
the discipline to invest in a Roth IRA account, then investing
in a 401K plan (even a poor 401K plan) is better than not
investing at all.
Conclusion: Everyone's situation is different, and there is no
one specific order for retirement investing that is perfect for
everyone. However, investing in your 401K up to the matching
percentage, and then opening a Roth IRA is a good strategy for
most people, as a combination of 401K and Roth IRAs could
provide you with the best of both worlds. Both types of accounts
have many benefits which can allow for flexibility and planning
opportunities when it comes to withdrawals and taxes, both
before and after you retire.