Should I Invest In 401k Or Roth IRA?
Many young investors have this exact question Should I Invest In a 401k Or Roth IRA? I m talking about a specific situation where someone already invested in the 401k enough to get company matching. After that, should you invest further in 401(k) or Roth IRA ?
Most people who consider investing assume that they should invest in Roth IRA because the investment will never be taxed again. However, the tax advantage of the 401k plan is still substantial even with no company matching.
Let s use an excel sheet to calculate which one is better for an average investor.
Here are some assumptions.
- The investor is in the 25% tax bracket. He can invest $5,000 in Roth IRA or $6,666 pre tax in 401k.
- 8% annual gain
- Investor retires at 60 and lives until 80. (A bit depressing.)
- Withdrawal rate is (total money left / years left to live.)
- After retirement, his income is derived solely from this portfolio, thus he has lower tax rate. This is a big assumption, but mostly valid. Most retirees make less money after they retire and pay less tax annually.
Here is the graph of the 401(k) vs Roth IRA.
As we expected the 401(k) portfolio grew much more than the Roth IRA because you start out with more money invested. The 401(k) portfolio grew to $815,558 at age 60 and the Roth IRA $611,668.
We need to zoom into the withdrawal period to see the differences between the two. This graph shows the income after tax.
The 401(k) plan has a bit of advantage here due to the lower tax rate after retirement.
At age 61, the 401k investor withdraws $40,778 from the 401(k) and receives $34,457 after tax. Assuming today s tax rate, the investor pays about 15.5% tax on this income.
Withdrawal formula (total value of portfolio/years left to live) = ($815,558/20) = $40,778.
The Roth IRA investor withdraws $30,583 and keeps the whole amount.
We can see that if you invest in 401(k), you ll have more retirement income even after tax. $4,000 might not seem like a large amount, but it is over 10% difference in income. In fact, the retiree will enjoy a total of $63,000 extra by investing in the 401(k) instead of the Roth IRA.
Of course, we made some assumptions above and the biggest one is that the tax rate will be lower after the investor retires. If the tax rate goes up in the future, then it maybe better to invest in the Roth IRA. I don t think this will be true for me so I will continue to put the 401(k) first.
What do you think? Is it better to pay tax now and invest in Roth IRA or wait to pay tax after you retire? Personally, I think it s better to max out the 401(k) first and then invest in Roth IRA. It s best to max out both 401(k) and Roth IRA so you can take advantage of both programs. What do you do currently?
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Jeanene V. October 15, 2012, 7:32 am
I have actually taken my money out of both of my 401k and my IRA and have invested both in real estate. I know it sounds crazy, and did to me at first also, but i am making a minimum of 8% every year! Neither my 401 or my IRA came close to touching the returns I am making. Retirement here I come, in about 30 years or so Good luck to everyone investing!
Lee R. December 28, 2012, 12:35 pm
I ve been contributing to a 401(k) for over a decade but there are no matching funds from my employer. But, my question is what to do with my money since I m within 3 years of retirement. I was considering rolling over my 401(k) to a Roth IRA but I ve read at foxnews.com that said that I have to keep my money in the Roth IRA for 5 years before I can withdraw money from it. Also, I m not sure if I should keep my money in the 401(k) because it s quite possible that the Obama administration will cause taxes to increase. Since I ll be eligible for retirement within 3 years, that wouldn t be good for me. Also, there s the possibility that the DJIA could drop to around 6000 again. If it s true that my money would not be available to me, at retirement, if I put it into the Roth IRA, and since taxes are likely to go up, it seems that I should take my money out now and put it into a low interest savings account. It sure is tough to know where to put my money. I ve even considered puting my 401(k) money into physical gold, also.
retirebyforty December 28, 2012, 3:17 pm
You can check the flow chart at the end of this post for more info.
Basically you can withdraw the contribution anytime, but you might have to pay penalties on the gain if you don t meet the conditions.
Your 401(k) should have a money market or bond options. Check with the plan. If you think the stock market will crash, then you can move your investment into a safer fund.
You probably shouldn t roll over the whole amount into a Roth IRA at once. You ll have to pay a ton of tax if you do that in one year.
Experts recommend moving more investments to bonds and cash when you re near retirement. Good luck!
Dan February 4, 2013, 12:15 pm
This is very interesting to me as a CPA. I, for one, believe that it is very unlikely that you will be better off contributing to a Roth vs. pre tax 401k s for most employed people. The reason is you take your 401k deduction at your highest rate of taxable income, say 25% for most professional single people, and withdraw the amounts at your retirement tax rates, which start at 0% and can climb to 15% or higher. However, you will need extremely large amounts of money to be taxed above 15%, particularly if you are married and your tax brackets are TWICE those of a single person.
I have both a 401k and a Roth IRA. My wife and I have saved and invested large sums of money and I actually believe now that I may be better off putting additional investments into a Roth because I may max out my 15% tax bracket at retirement. However, my work does not offer a Roth 401k that I would like, so I simply put money into a pre tax 401k. I d rather have this account be over funded than under funded. Over funded is an easy problem to solve, under funded is much more challenging.
Most people should not only contribute to a pre tax 401k up to a company match, they should max this out before considering a Roth at all. At age 65, both singles and married couples also get an additional standard deduction, $1200 for one person and $2400 for a married couple, so that s even more income, (indexed for inflation) that will be taxed at 0% when you retire instead of 25%.