401K Vs. Roth IRA

Clients often ask whether they should utilize a 401K plan or a Roth IRA. Here is a quick outline to help:

The benefit of a 401K plan is deferred taxation on portions of your current income until retirement, when you will hopefully be in a lower tax bracket. The money you put away, plus the growth on that money, will be taxed at a lower level when you withdraw it. In theory, this will work out well as long as taxes do not increase (a real possibility). One HUGE benefit to employees with a 401K plan is an employer matching provision. If this is the case at your company, take advantage of that benefit to the fullest extent! It’s free money!! A five percent match means you contribute five percent of your yearly income and your employer puts in five percent too. It’s like getting a 100% rate of return annually!

The Roth IRA is an Individual Retirement Account that allows you to invest money after you’ve paid taxes on it. You do not get to write off the amount you put into this account on your current taxes like you do with a 401K contribution, but funds in your Roth grow tax-free. At retirement, you get to withdraw qualified amounts without paying taxes on it! I encourage the use of the Roth IRA as a retirement savings vehicle because it eliminates future tax policy as a variable. The national income tax could increase to 50%, but in theory, the money you withdraw as a qualified distribution will have no tax.

When faced with a choice between saving through a 401K plan or a Roth IRA, here are some questions to ask:

  • Does your Employer Match any portion of your contribution?
  • If yes, then put in at least up to the amount they match (it’s free money!)
  • Do you think taxes will decrease in the future?
    If no, you probably should start saving some money in a Roth IRA.

I often advise people to put into their 401K plan at least what their employer will match, and if there is money left over put the remainder into a Roth IRA. This provides two different pools of money to draw from during retirement.

As always, these are general rules and your own personal situation should be reviewed with a financial advisor.