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:
|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.
- 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.
- 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%.
|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?