Ah, the age-old question*: should you use a 401k or a Roth IRA to save for retirement? In many ways, the 401k vs Roth IRA choice is a false one. For most people who fall under the Roth IRA income limits (phase-outs begin at $107,000 for single filers and $169,000 for married filers in 2011), there’s no reason you can’t do both. The generally-accepted rule of them is that you should invest in your 401k up to the company match, then max out your Roth IRA, and only then return to max out your 401k plan. But why is this the generally-accepted order of things? To answer that question, we need to understand a few features of each.
401k Tax Treatment
Traditional 401k plans are highly advantageous for high-income investors because they allow an immediate tax deduction for the full amount of your contributions. For example, if your income is currently taxed at the maximum marginal federal income tax bracket, it’s unlikely you will be taxed at an even higher rate in the future, even if overall tax rates go up. This is because you probably won’t have (or need) as high an income in retirement as during your working years. Thus, high-income investors are often better off taking the current tax benefit rather than deferring it. For low- or middle-income investors, however, this probably isn’t the case.
The main disadvantage of 401k plans is the way withdrawals are taxed. Specifically, 401k withdrawals are taxed as regular income at your full marginal income tax rate and now the lower long-term capital gains rate enjoyed by taxable investors. Because of this, low-income investors likely to have a higher income in retirement (due to their diligent saving and disciplined investing in portfolio of low-cost index funds) are probably better off paying taxes today in exchange for tax-free withdrawals tomorrow, which is where the Roth IRA comes in.
Roth IRA Tax Treatment
Roth IRA’s (and their new cousin, the Roth 4o1k) trade an immediate upfront tax deduction for tax-free withdrawals at retirement. That’s right, folks. Even though you get no tax benefit for contributing to a Roth IRA today, your earnings grow without the drag of taxes and you will be able to withdrawal from your account 100% tax free. Thus, the Roth IRA is generally a better bet for low- to medium-income investors who expect their incomes to rise over time.
So Which to Choose?
While there are of course a plethora of exceptions to every rule, in general the Roth IRA vs 401k question comes down to two factors: your current income and your expected future income. Thus, it is possible to make a few limited generalizations. It’s probably safe to say that if you’re in the two lowest income tax brackets (10% and 15%), you are almost certainly better off investing in a Roth IRA, particularly if you expect your income to rise in the coming years. If you are in the 28% tax bracket, you are likely slightly better off investing in a 401k versus a Roth IRA, however, the advantage is not a very large one. For those in the 25% tax bracket, it’s more or less a toss-up.
But You Should Invest In Both Anyway
Now here’s where many people get lost. The fact is, you should probably invest in both a 401k and a Roth IRA (and a taxable account, too!) regardless of what the math says. Why? Because we have no idea what tax rates will be in the future. If taxes go up dramatically, a 401k because relatively less attractive. And if they go down, a Roth IRA becomes relatively less attractive in turn. Having a significant sum saved in several different types of accounts with different tax characteristics will give you the flexibility you need to make the best tax decisions in the future. If you hold all your retirement assets in, say, a 401k plan, you may find you’ve invested yourself into a corner.
* Age-old in the last-few-decades-they-have-existed sense.
Amateur Asset Allocator
401k Vs Roth IRA For Retirement?