Question

Evaluate the following statement: 'A 401-k offers a guaranteed tax free income stream while a Roth IRA is subject to market risk and taxes on capital gains.'

Answer 1

Although both are good options worth considering, the answer isn’t always as straightforward as one might think. Also, it’s crucial for you to understand that you may not even need to pick one or the other. If you’re able to contribute to a work-sponsored 401(k), there is no reason you can’t also contribute to a Roth IRA, provided you meet certain conditions.

As a side note, if you’re looking to get a Roth IRA, The Simple Dollar recommends Scottrade as a good choice due to best-in-class customer service and support.

Before we delve deeper into this debate, let’s first make sure we have a working understanding of each of these options for retirement and what they entail.

What Is a 401(k)?

A 401(k) is an employer-sponsored deferred contribution retirement plan, so named because it’s defined under section 401(k) of the IRS code. In a nutshell, it works like this: You sign up for a 401(k) plan in your workplace and choose investment options within the plan. Your workplace takes money out of your paycheck before income taxes are taken out and deposits this in your plan. In some workplaces, your contributions are matched by the employer.

Then, when you reach retirement age, you can take money out of the 401(k), but those withdrawals are subject to income tax – since you didn’t pay it earlier, you have to pay it later on. (The benefit of the deferred tax structure is based on the assumption that you’ll be in a lower tax bracket in retirement compared to your prime earning years.)

Currently, there is no upper income limit on who can contribute to a 401(k), but an individual could contribute at most $18,000 to his or her 401(k) in 2016, and the maximum total amount that can be contributed between employer and employee is $52,000 in the same year.

Benefits of a 401(k)

• Your contributions may result in tax savings during each year you contribute.
• Your employer may offer an employer match — a.k.a. free money.
• In most cases, the money you contribute can be taken directly out of your paycheck. Out of sight, out of mind.
• You can contribute a lot more each calendar year using this option (up to $18,000 per year in 2016)

You can find a lot more detail on IRS.gov.

What Is a Roth IRA?

A Roth IRA is an independent individual retirement account that you set up directly with an investment firm. Its name comes from its chief legislative sponsor, Senator William Roth.

With a Roth IRA, you can set up an account with any of the online brokers, choose investment options with them, and then directly deposit after-tax money (from your checking account, for example) into the Roth IRA. Then, when you meet a few basic requirements (once you’re 59 1/2 years old or older, and have had the plan for five years or more), you can withdraw both your deposits and investment gains completely tax free. You can also withdraw funds penalty-free to pay for a child’s education or a down payment on your first house.

In 2016, the maximum contribution you could make to a Roth IRA is $5,500 a year (unless you’re over 50). However, there is one big caveat: There are income limits on who can contribute. If you make more than $116,000 individually or $183,000 jointly, you can’t contribute the full amount (and may not be able to contribute at all).

Roth IRA Benefits

• Your eventual withdrawals will be tax-free since you funded your account with after-tax dollars.
• You can actually withdraw your contributions at any time without penalty. (You cannot begin withdrawing your earnings before age 59 without incurring a penalty)
• Unlike with a work-sponsored 401(k), your Roth IRA will allow you to pick and choose a brokerage firm and your individual investment options.

Roth IRA vs 401(k): What Are the Major Differences?

The big differences between the two are employer contributions, investment options/management, and taxes. Let’s look at each aspect.

Employer Contributions

With a 401(k) retirement plan, an employer may match contributions made by an employee up to a certain percentage. For example, let’s say you contribute 10% of your gross salary to your work-sponsored 401(k). In some cases, your employer will match your contributions up to a certain percentage, usually somewhere between 3-6%.

When your employer offers a perk like this, it is crucial that you take advantage of it. It’s free money, after all – don’t turn it down. In a nutshell, employer contributions are also one of the advantages of using a 401(k) in the first place. Since a Roth IRA is funded only with your after tax dollars, you won’t receive this benefit when you use that particular type of account.

Advantage: 401(k)

Investment Options/Management

Although receiving an employer match when you use your 401(k) can be rather attractive, that doesn’t mean that using that particular type of retirement account doesn’t come with its own set of drawbacks. With a 401(k), you’re tied into whatever management and investment options are made available to you by the plan your company offers. In some cases, that means that your choices could be rather sparse and not all that great, although that isn’t always the case.

Important items to look out for in your investment plans are expense ratios and investment options. The best employer plans will have low expenses and as many options as possible.

With a Roth IRA, you are allowed to choose your management and thus also your investment options – you pick the investing house you want to use. Roth IRAs offer an advantage in that they allow you to choose your plan’s manager, though if your 401(k) offers good options, this may not be a big advantage.

Advantage: Roth IRA

Taxes

Another big difference between a 401(k) and a Roth IRA is the way taxes are paid on both your contributions and your withdrawals. In short, your 401(k) plan is funded with pre-tax dollars, which can be beneficial since it reduces your tax liability during each year you contribute — often in the prime of your career. However, the money you eventually take out of your 401(k) will be taxed upon withdrawal at your current tax rate.

Meanwhile, a Roth IRA works in almost the exact opposite way. The money you contribute has already been taxed, which means that making a Roth contribution won’t affect your taxable income in the year you contribute. However, since you have already been taxed on your contributions, you won’t need to pay taxes when you begin withdrawing funds for retirement.

Advantage: It depends on your tax rates

How can you know which rate will be higher? Here are a few things to ask yourself.

Will my income increase between now and retirement? If the answer is yes, you’ll likely be in a higher tax bracket when you retire, which favors the Roth. If you’re near your peak, you’ll probably be in the same bracket or lower, which favors the 401(k).

Will I be working in my retirement years? If the answer is yes, you have a much higher chance of at least being in the same tax bracket you are now.

Will the political landscape shift towards higher tax rates? This one, honestly, is complete guesswork. If I had to guess, I would speculate that tax rates will go up in the future. If that’s the case, you might want to lean towards a Roth IRA since your future distributions will be tax-free. If you expect to pay a lower tax rate in the future, however, a 401(k) funded with pre-tax money might be a better bet since you won’t be taxed on that money until you retire and begin taking distributions.

Best Strategies for Maximizing your 401(k) or Roth Contributions

Contributing to at least one type of retirement account faithfully is crucial if you ever hope to retire. In most cases, Social Security funds will not be enough to sustain you, and your cash savings probably won’t have the opportunity to grow the way they would if you had invested that money all along.

When it comes to picking between a Roth IRA and 401(k), there really is no perfect answer. Your individual situation will impact which plan works best for you, and even then, there are several different ways to look at it.

It’s also important to note that you don’t have to pick one type of account over the other. You can contribute up to $18,000 to your 401(k) and put up to $5,500 in a Roth IRA or traditional IRA that same year. Here are a few different strategies you might want to consider as you move forward.

Max out your 401(k) and contribute to a Roth. If your work-sponsored 401(k) offers low fees, plenty of options, and an employer match on your contributions, you might want to max out for your 401(K) and contribute to a Roth IRA. This is a great strategy for anyone who has extra money to invest and wants to lower their tax liability.

Contribute to your 401(k) up to the company match, then begin funding your Roth IRA. If your work-sponsored 401(k) doesn’t come with the best options but you still want to take advantage of your company match, you could always contribute a percentage equal to what your employer has pledged to contribute, then focus on contributing to your Roth IRA. Young people especially should consider the future benefits of a Roth IRA since many experts agree that tax rates could go up significantly over the next few decades.

Contribute a set amount to each type of account each month. If you are struggling to decide which type of account will benefit you in the long run, you might just want to split the difference and contribute equal dollars to both. Set up your 401(k) contributions to include a percentage of your income that you can easily match in your Roth IRA. Then make a commitment to invest every month, no matter what.

Choosing the Right Option

Whether you’re choosing between a 401(k) or Roth IRA, or simply trying to choose which brokerage firm you want to use to make trades or manage your investments, it’s important to remember that there is never a one-size-fits-all option. To figure out what is best for you, you have to explore all of the pros and cons with each opportunity and figure out how they relate to your own situation.

The most important thing to remember is that, in most cases, time is on your side. The earlier you start investing and saving for retirement, the better off you’ll be. So take time to choose which type of retirement options is best for you, but don’t let having too many options deter you from making a decision altogether.