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Which should I invest in Roth IRA or 401K?

As you read around the world of personal finance you will hear a lot about Roth IRA and 401K Investments. However, you may not understand all the benefits and pitfalls of each. Both are ultimately superior to taxable accounts in almost all situations, provided you know what you’re​ doing.

What are 401K>

401K Investments are actually a family of investments. There are also 403B, solo 401k, and 457B which cover other organization types. The basics of a 401k are you can have cash deducted from your paycheck, or as a self employed individual from your revenue, tax free. The money earns interest over the years and you pay taxes when you withdraw the money. The obvious benefits are that you have taxes applied to you at the rate when you retire instead of the rate today.

So depending on how on top of things you are when you retire, you can manage your income to be in a lower tax bracket and thus decrease your tax exposure. This is the difference you would use when comparing to a Roth IRA or 401K, your applicable tax rate.  Regardless of your tax bracket the 401K will be superior to your taxable account. No matter what happens to the tax rate, you do not pay Capital Gains Tax with the 401K.

Imagine this, you have a tax rate of 30%, 15% Capital Gains Tax rate, you earn a 5% return, and have a 143 dollar paycheck to invest. For the taxable account the 143 is immediately reduced to 100.10 due to taxes. Your 401k however gets the full 143 dollar investment. Your return over the years looks like this:

Time401KTaxable
0$143.00$100.10
1$150.15$104.35
2$157.66$108.79
3$165.54$113.41
4$173.82$118.23
5$182.51$123.26
After 401k Withdrawl Tax$127.76$123.26

So in the 5th year after paying the same tax rate as you would have in year 0 for the taxable you’re now $4.50 ahead or 4% in just 5 years. Over a life time obviously the number gets even larger.

Now of course a 401k has a withdrawal penalty to keep you invested. If you withdraw before 59.5 you will owe a 10% penalty. However, even after the penalty the 401k comes out ahead in longer stretches. In fact there are only two scenarios where the 401K will come out behind provided the laws stay roughly the same.

  1. Sky High Expense Rates in a 401K. Usually you are at the mercy of your 401K provider on what your choices are. Depending on the rate you may be better off investing elsewhere. Try to focus your money in your 401k on your best choices and manage your allocations amongst multiple account types to keep costs low.
  2. You need the money for an emergency. This is why you always need an emergency fund whether it be money elsewhere or access to money.

Beyond 401Ks there are also Roth IRAs and Roth 401Ks. These essentially shift the tax payment to the front from the back. So you pay your tax before input instead of at removal as in the 401k. In the case where your tax rate remains the same from input to withdrawal these are fundamentally equal. Imagine again the same scenario of 143 dollars dollars available pre tax to invest.  The tax rate at investment and withdrawal in this example are the same at 30%.

Time401KRoth
0$143.00$100.10
1$150.15$105.11
2$157.66$110.36
3$165.54$115.88
4$173.82$121.67
5$182.51$127.76
After 401k WithdrawalTax$127.76$127.76

So, see no difference. However, the issue is you tend to make more when you’re​ working then when you’re​ likely to retire. Also when you retire you likely will have a greater opportunity to control how much you make for tax bracket purposes. As such if tax rates stay the same, your 401k withdrawal will likely be in a lower tax bracket then when you contributed to your Roth. So in theory the 401k is superior to the Roth. In practice the book is not written on taxes yet, things could be a lot different in 30 years. In fact the government could even change the rules against these investments. That means in my honest opinion if you can swing it I suggest you do both.  Consider investing the the 401K up to the match and then investing in a Roth IRA.

One additional advantage of the Roth over the 401K is you can also withdrawal the principle penalty free, though you still will be penalized if you touch the earnings. In theory you should never touch your retirement savings for regular things, but emergencies can happen and it’s nice to know if needed you can get to this savings.  While you can loan money from your 401K, it comes with strings like you cannot leave your employer without paying off the loan.  The Roth has less strings attached.

HSA, Savings Bonds, and 529

There are 3 more investment vehicles I’d be remiss in not mentioning that are in certain circumstances superior to Roth and 401K both. HSAs are superior for medical usage as you can contribute, withdraw, and earn interest without paying taxes provided you use the money for medical purposes.

529 and savings bonds allow you to earn interest without paying taxes when used for education. Depending on your future plans these may be fantastic investment vehicles. However, proceed with caution as it’s probably not advisable to save for education and health at the expense of retirement living expenses.

Ultimately like anything else your decisions on which of these investments to use are largely personal, but hopefully this post helps you to more understand your decisions.

Do you invest in a Roth, 401K, HSA, 529 or other tax advantaged account? How do you allocate between these accounts?

15 Comments

  1. Personally my highest priority is to max out my “traditional” 401k ($18k per year) and for my wife to do the same. We are in a high tax bracket, so this provides an immediate benefit as you pointed out.

    Priority 2 is to max out our IRAs via a “backdoor Roth”. Because of our income, we get no deduction for a traditional IRA.

    With retirement contributions maxed out, I consider other accounts as nice to have but not essential. In a pinch, one can borrow money for school but not for retirement. Ideally, we’ll still have enough left over to make consistent contributions to the HSA and 529. The HSA, especially, has excellent tax benefits over time.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 19, 2017

      I do not qualify for a Traditional IRA either. We do qualify for a Roth IRA. It sounds like we are largely of the same mind on contribution cadence.

  2. Mrs. Need2save
    Mrs. Need2save May 19, 2017

    I like to think that there is a magical crossover point as your income rises where switching from Roth to Traditional or 401k deductible contributions makes sense. But for a little while in between it pays (saves) to do both. So glad you mentioned HSAs and 529s as well.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 19, 2017

      There definitely are, especially with items like IRAs having income cutoffs and 401ks having company highly compensated employee contribution limits.

  3. Leo T. Ly
    Leo T. Ly May 19, 2017

    I invest my in both my retirement plans and taxable accounts. Deferring my income tax now and use the money to compound my savings allows me to achieve financial independence a lot sooner.

    To avoid touching my retirement savings, I have built access to funds that’ll allow me to cover 99% of emergencies. This way I don’t have my money locked up and I can invest it to make more money.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 19, 2017

      I have an upcoming post on this, that is rather US centric admittedly, but the retirement plans in the US have ways around the lockup period. The funds may not be as locked up as they appear.

  4. Kevin @39months.com
    Kevin @39months.com May 19, 2017

    What I have often seen, and what I practice, is to go with the 401K till you hit the point where your employee matches (my employee matches 1/2% up to 3%, so I put in 6% and they match 3%).

    Then fully fund your Roth IRA (if you can, since those who make too much can’t put in – poor high income folks). This provides you with a little more flexibility than the 401k, as you noted in the article. It also is the last stuff I intend to draw down in retirement, as it can be easily passed on.

    Then fund your 401K up to where you max it out

    I’ve followed that for about the last 10 years, and its worked well.

    What I find interesting is that some financial advisors (Ric Edelman being one) is starting to warn about paying the taxes up front with the Roth IRA, and expecting the tax break to be there in the future. This is a major shift in the advisor field – the thought by them that the tax code for Roth’s might change. It must be a serious concern if they are openly talking about it on radio shows, etc!

    • fulltimefinance@fulltimefinance.com
      [email protected] May 19, 2017

      At least they have yet to mention it in the house. They already floated killing 529s once. I do worry that it is an inevitability, especially with the back door capability making it easier to label it a method for the rich.

  5. SMM
    SMM May 19, 2017

    I give #1 priority to my 401k. I’m working on maximizing my contribution to that – easier said than done 🙂
    I know it sounds weird, but I sometimes think about Roth like paying my bill early before it’s due. I just prefer to prioritize on tax-deferred accounts that hold on to all of my investment earnings, but I may venture out to this in the future!

  6. Dan
    Dan May 19, 2017

    My priority list is:

    #1) 401k pre-tax Contribution up to my employee’s matching contribution
    #2) Roth IRA (I have to a traditional IRA limit of $5500/year with no tax benefits and then do a “backdoor conversion” to a Roth IRA)
    #3) 401k pre-tax contribution up to the IRS pre-tax limit of $18,000/year
    #4) 401k after-tax contribution up to the IRS total limit of $54,000/year

    I cannot remember the last time I did not max out #1 to #3. I’ve never maxed out #4. In a few years, I’ll be old enough to make catch-up contributions to the 401k and IRA. I’m not sure if I’ll be able to max out #1 to #3 at that point but I’m not sure if I’ll be working either.

    I take the after tax 401k contributions and periodically convert them to Roth IRAs.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 24, 2017

      It sounds like your making great progress towards your goals. Thanks for the comment.

  7. Friendly Russian
    Friendly Russian May 19, 2017

    Our current strategy is:
    1. Traditional 401(k) up to the match (my employer matches 75% on first 6%, my wife’s matches 50% on first 6%)
    2. Max out two Roth IRAs
    3. Taxable account – we are saving for a house

    But as of yesterday we decided to change it a little bit
    1. Max out both Traditional 401(k)
    2. Max out both Roth IRA(s)
    3. Participate in EPP up to the limit
    4. Taxable account

    Will see how it goes

    • fulltimefinance@fulltimefinance.com
      [email protected] May 24, 2017

      We recently added in ESPP to our flow as well. It looks like a good deal with low risk so long as you sell on issue. Holding your companies stock for any length of time is probably not a good idea. I’d be interested in hearing how it works out for you.

  8. I never had to make that decision. My first year working I was barely saving any money while working on a fellowship. When I moved to full time for my second year it came with a $25k raise. I decided to use that to max out my 401k and Roth IRA, as I was living fine on my salary. I’ve maxed both every year since.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 24, 2017

      It certainly is easier if you can do both and you setup the ability up front. We also do both.

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