401(k) or Roth IRA?
For many people (me included), maxing out both a 401(k) (or 403b) and Roth IRA isn’t feasible. (Ok - for us, it’s feasible, we’ve just chosen to go a different way with our money.) Everyone must make the same decision with their money - how to allocate it. You could max out a Roth IRA, but maybe you’d rather eat out often. That’s a perfectly valid decision assuming you’ve actually made the decision consciously.
So if, like many people, you’ve decided maxing a 401(k) and Roth IRA is an either/or proposition, you have a big decision to make.
Is it better to save in a 401(k) or a Roth IRA?
Here is a head-to-head comparison of the 401(k) and Roth IRA. Assuming you’re eligible for both, this guide should help guide you to the right retirement savings account for you.
- Investment Options
Many 401(k) plans offer an inappropriate number and type of investment choices. Plans can have either too many or too few choices. Too many can cause investor paralysis or a ‘little bit of everything’ allocation. Too few choices can cause a dangerous overweighting in one asset class and other problems. Another problem with 401(k) plans can be the investment options themselves. Funds that are expensive in terms of load and/or management fees directly and dramatically affect your account balance at retirement.
On the other hand, a Roth IRA can be invested in almost anything. You can invest in Exchange Traded Funds (ETFs) with their low-fee advantage. You can choose mutual funds, fixed income assets (e.g. bonds), Real Estate Investment Trusts (a kind of real estate ‘mutual fund’), or most anything else. Being able to invest in whatever you want obviously is a great advantage because you’re not limited to your company’s investment choices.
Advantage: Roth IRA
- Access to Funds
You might need access to your savings prior to retirement for any number of reasons. While it’s almost never advisable to withdraw money you’ve saved for retirement before actually reaching retirement, circumstances sometimes dictate that course of action. For example, an extended job loss may require you to dip into retirement savings.
Most 401(k) plans offer an option to borrow some of what you’ve contributed. If you take this route, you pay the money back just like any other loan. Effectively, the loan payment comes right out of your paycheck and goes back into the 401(k) account.
The main thing to note about 401(k) loans is that, with most plans, you must pay any remaining balance in full immediately upon leaving your place of employment. If you can’t, the loan becomes a distribution with all the major disadvantages that come with those.
You can get money out of a Roth IRA in an emergency, too. There are two major differences with a Roth, though. First, the money you take out is not a loan. You can’t put the money back into your IRA once you take it out. That’s a major downer because you’re forgoing all the compounding that money would have had until retirement.
Second, you can always withdraw your initial contribution penalty-free. In other words, you can get at the money you put into the Roth IRA any time, but cannot get at the gain on that investment without penalty. So if you invested $1,000 and the account balance is now $1,500, at most you can withdraw the $1,000 without penalty.
Advantage: Depends. If you are confident you’ll be able to repay the money and will remain employed until you do, a loan from a 401(k) is the way to go. If the money won’t likely be repaid (e.g. a house down payment), use the Roth IRA.
- Creditor Shielding
The 401(k) is protected from creditors under federal law. You can be forced to surrender part in a divorce, but not in the event of a judgment or bankruptcy.
The Roth IRA, on the other hand, is at the whim of state law. As such, it’s possible a creditor could attach your Roth IRA depending on the state you live in.
Advantage: 401(k)
- Matching Contribution
Some 401(k) plans include a employer match. Typically, for some percentage, your employer will match your contributions. If your plan offers a match, not contributing up to this maximum is leaving free money on the table. There are times, however, when it may make sense to forgo an employer match and save outside the 401(k).
Naturally, the Roth IRA offers no matching contribution. You’re on your own with a Roth.
Advantage: 401(k)
When weighing whether to invest in a 401(k) or a Roth IRA, give these four points some thought. The answer won’t be the same for everyone, but thinking it through will help get you to a nice comfy retirement.
401k ira
October 31st, 2007 at 6:52 pm
Nice assessment of key things to think about when choosing to fund a 401k and/or Roth.
In the Investment Options section you cite too many choices as being a detriment of some 401k plans, while at the same time you say that being able to invest in almost anything with a Roth is a positive. While I personally lean toward the “more choices the better” side, it does require significantly more vigilance and research to maintain a solid portfolio. I’d say that the advantage here really depends on the breadth and quality of funds offered in a particular 401k.
As for the Matching Contributions, unless the fund choices are truly horrible, or the matching percentage is obscenely low, I personally cannot see any circumstance where foregoing the “free money” from a matching contribution makes any sense. Certainly, in most cases there is a decision to be made once the full matching contribution is covered, do you contribute more to the 401k or divert excess investment funds to a Roth. I’d be interested to know of other considerations that make a Roth more attractive than a 401k with matching contributions?
November 1st, 2007 at 8:25 am
EJD - I see what you mean about the ‘choices’ bit. What I was trying to convey was that research has repeatedly shown too much choice is bad. So in a 401(k) plan with many, many choices, people who aren’t experienced with investing typically do one of two things. They either spread their contributions evenly among the choices or put all of it in company stock or a cash equivalent. Neither one of those is a good choice.
With a Roth, you avoid a lot of the potential negatives of a bad 401(k) plan. Namely, you can choose a low-cost version of just about any fund type you want. With a 401(k), you’re stuck with whatever the company offers. But I do see your point.
I wrote a post about what to do if your 401(k) sucks (it’s below in the ‘Related posts’ section). In it, I say it’s almost never advisable to pass on a company match, even if there is nothing else good about your plan. So I think you’re right there.
November 1st, 2007 at 10:23 am
Roth 401(K) has some other advantages over tranditional 401(K)
Roth 401(K) offers tax free earnings which will be better choice if you (1) expect substantial earnings (2) have a higher tax bracket when you retire.
A Roth 401(K) can be rolled to a Roth IRA which does not require mandatory distributoins at 70.5yrs.
November 1st, 2007 at 2:55 pm
the other point omitted is the higher contribution limits of 401K versus IRA.
November 11th, 2007 at 8:32 am
Hmmm.
Self-directed Roth IRA? Self-directed regular IRA even. Self-employed 401(k)?
I don’t think there’s a either/or comparison to be made. If you can do both, do it. The regular advice seems to be max the 401(k) until you get the full match, then max the (Roth) IRA then top off the 401(k).
I personally say max the 401(k) first to reduce AGI. That alone saves me every year. Probably not helpful if you’re making 115K but under that, I think its an automatic win.
March 13th, 2008 at 12:40 pm
I switched to a self directed IRA and am investing in real estate the investment options are excellent.