This question was asked in the comments section for my post Calculating the True Costs of 401(k) Contributions:
I think this is likely a dumb question but I need it answered once and for all! My company doesnâ€™t match 401(k) contributions (they contribute $25 per pay period regardless). So shouldnâ€™t I fully fund a Roth IRA before contributing any money into my 401(k)? Itâ€™s better to having money grow for 30 years than get the pre-tax benefit and then have the growth taxed at the end, right? Iâ€™m 37, btw. – hickory
Here’s my response:
Hickory, in order to answer your question specifically for you I would need a lot more information. However, I can offer up a generic response. Your question isn’t stupid. In fact, it is probably one of the most asked questions when it comes to 401(k) plans and IRAs. The answer depends on several factors:
1. Are you eligible to use a Roth IRA? If your Modified Adjusted Gross income is $95,000 (single filer) or $150,000 or less (married filing jointly), you can contribute the full $4,000 to a Roth IRA.
2. Your tax bracket now vs. your tax bracket when you retire. Of course, none of us know what the tax system will be like a year from now, much less 30 years. However, if you are young and are saving a lot of money and are investing it properly, it is conceivable that you could have a substantial asset base once you retire. The bigger your asset base, the more money you will be able to withdraw to live on. Of course, the more money you withdraw, the greater your tax burden.
If you expect that you will be in a higher tax bracket during retirement, then it makes sense to fund your Roth first and then use your 401(k). If, however, you think you will be in a lower tax bracket when you retire, then it would make sense to take advantage of the pre-tax feature of your 401(k) and save tax dollars now.
3. Your expected income sources upon retirement. Did you know that Roth income do not count against you when it comes to deciding the taxability of Social Security payements? The Roth could potentially allow you to escape taxation of your Social Security payments.
Also, there are no Required Minimum Distributions from Roth IRAs. So, if you didn’t need the money, you could allow your Roth to grow throughout your retirement and use the money when you needed it. This isn’t an option with other retirement accounts.
4. Do you want to leave tax-free income to your heirs. You are 37 now so thinking about heirs seems a little premature. However, if your plan works out, it is possible that you will have a nice nest egg to pass on to your beneficiaries. A Roth IRA that is properly set up, would allow you to pass tax-free income to your heirs that they would then be able to withdraw based on THEIR life expectancy. This could potentially mean hundreds of thousands of tax-free income over their lifetime.
I’m sure there are other things to consider, but these are some of the basic questions to think about.
In a nutshell, a Roth IRA is great alternative to a 401(k) as long as you understand the tax consequences. I would recommend you play around with the numbers using a tax program like Tax Cut or Turbo Tax and see how your decision impacts your current tax situation. Remember, that some deductions like medical expenses are based on your Adjusted Gross Income. So, it would be smart to look at your deductions and see if contributing to a 401(k) would help you out there since a 401(k) contribution reduces your taxable income.
I hope this helps.