Roth v. 401(k)

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 doesn’t match 401(k) contributions (they contribute $25 per pay period regardless). So shouldn’t I fully fund a Roth IRA before contributing any money into my 401(k)? It’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? I’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.

7 thoughts on “Roth v. 401(k)”

  1. Wow – thank you so much for your thoughtful response! A few answers .

    1. Oh I’m mad eligible for the Roth and I’m sure I (we) always will be since I’m a social worker and my wife is a teacher (in the South).

    2. I don’t know squat about tax rates but a quick Google search says that normally my wife and I will fall in the 25% rate, but currently with the wife home with child we qualify for the 15% rate – nice! We’ll never be big ballers so I would expect we’ll generally be in the 25% (or future corresponding) bracket for the next 30 years.

    3. Both of us will have our state pensions (or something similar) and social security, so nothing extravigant or high income.

    4. Heirs? We’ve got one child and might make another but I don’t think leaving them thousands in tax-free income will ever be a big priority. We are putting money in a 529, however.

    Okay, so it sounds like funding Roths is the way to go for us since we’re not in a burdensome tax bracket now, and we will likely be in the same bracket at retirement. If I’m misunderstanding what you are saying then sock it to me.

    Thanks again!

  2. Just passing through and skimmed your question and answer so I hope my comment is on target. Do yourself a favor and fund more of your own retirement before adding to a 529. You lose out on financial aid big time by saving in your child’s name versus your own.

  3. I have a question for you all. I’m 31 YO and just finished paying off my credit cards! 🙂 I currently have a 401k but now with the extra cash, I’d like to either start a traditional IRA or to start investing in mutual funds. What are the pros and cons of doing one over the other? I don’t qualify for a Roth IRA, so it’s either going to be putting $4k to the IRA, annually, or putting $4-5k to the mutual funds.


  4. My 2 cents, for what its worth.

    A 401K is only a good deal to the point that you are getting the match from your company. If you are not getting a match from your company you should go ahead and fully fund your ROTH IRA’s in good mutual funds. You should be able to average over the years at least 12% growth with mutual funds.

    Another key factor is that you should be putting in at least 15% of your gross income into retirement. So if you max out your ROTH IRA’s and still have money left over, then you can put that into your 401K.

    Your mutual funds should be broken out into 4 categories.

    25% in growth funds
    25% in growth and income
    25% in Aggressive growth
    25% in International

    Again, let me know if you have any questions.

    Thats my two cents, for what its worth.


  5. Hi,
    Along similar lines I want to know if Roth IRA is the way to go for me.. Currently my company started an IRA plan this year but sadly with no match. This is my first job, I’m 23 and single filing status and about 45K income this year. I’ve but in about 3K into my 401K plan.. Im currently in the 25% bracket and dont know what ill be when i retire.. ( but if I am starting this young and saving money, then the tax free retirement plan is better right?)

    Do you have a calculator of how much I can expect to have if I contribute the max of 4000K for the next 10 years ( plan on reaching income limit then)

    Any help on if I should use the ROth or 401 k would be appreciated.. also, I have NO Idea how to set one up.. are there companies that offer this package like openheimer, wachovia? Do i go to them?? Please help

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