Roth IRA's vs. 401(k) Plans

With a profusion of alternatives and companies vying to procure investments in retirement plans, investors need to start at the top and work their way down through the choices. For purposes of this discussion, we limit ourselves to Roth IRA’s and 401(k) accounts. Should you contribute the maximum allowed contribution to a Roth IRA and invest the balance into your 401(k) or focus on the 401(k) and leave the Roth IRA as a secondary savings vehicle for remaining funds, if any?

The obvious advantage with 401(k) accounts is that your employer will likely provide matching funds for your contributions. This basically means that you are getting free money, which you won’t get with an IRA. This leads to the conclusion that you should max out your 401(k) account first, and then use additional savings to fund an IRA.

The Roth IRA has many advantages over a 401(k) such as being able to withdraw contributions ( principal only ) without penalties. Also, the value of a Roth IRA lies in the fact that all withdrawals ( principal and earnings ) are entirely tax free. Thus, when it comes to the ‘actual’ value of your total savings upon withdrawal, a Roth IRA reflects an accurate figure, while a 401(k) is funded with pre-tax dollars and the amount of cash you are finally left with is going to be less the applicable tax.

That said, both the Roth IRA and a 401(k) account are subject to strict rules regarding eligibility, annual contribution limits and other regulations which apply to retirement plans. One of the main deciding factors which will help you favor one of the two accounts is your expected tax bracket in future. Upon retirement or at the age when you expect to withdraw the funds, what tax bracket are you likely to fall under?

It is a tough job to predict tax rates at a specific point in the future and when you factor in the fact that you cannot accurately forecast your own situation at that specific point in the future, it becomes a guessing game to arrive at a figure. Add to that the confusion over what Congress intends to do with 401(k) accounts and the uncertainty over employer provided benefits.

A good solution to this conundrum is to hedge your bets and balance contributions to both the Roth IRA and the 401(k), so that you are able to take advantage of whatever tax deferral savings and employer contributions the 401(k) presents and a specific and accurate amount of tax free savings in the Roth IRA. Thus, the title of this article, which says Roth IRA vs. 401(k), should really be changed to Roth IRA + 401(k).

Please note that both IRA’s and 401(k) accounts have inherent advantages as also complex governing regulations and you advised to consult your financial planner while making decisions to fund any retirement plan(s). Review your decision every six months, or at least annually, to make sure the IRS has not come up with new regulations as also because you may be in a position to increase contributions to either or both the Roth IRA and the 401(k) account.