Roth IRA Versus 401k -- Which is Better?

I've stated before that I think there's a specific order to how most people should save for retirement -- and that starts with contributing to a 401k to get the complete company match. But what if your company doesn't have a match (or what if it does but you've met it and want to know what to do now?) Yahoo addresses the question of which is better -- a Roth IRA or a 401k without a match:

The rule of thumb is that, if eligible, you should contribute to a Roth IRA if your current marginal federal income tax rate is less than the rate you expect to face in retirement.

So, if your tax rate is higher now, go for the 401k (where you get a tax break this year and the money grows tax deferred.) If you expect your tax rate to be higher in retirement, then go for the Roth IRA (where you get no tax break this year but you do get tax free withdrawals.)

So, who has a crystal ball that can see into the future and determine whether your tax rate will be higher or lower in retirement? That's all we need to make this an easy decision. ;-)

A few other comments:

1. The 401k with the match is the winner by far -- do NOT pass it up.

2. For those that don't qualify for the Roth because their income is too high, the question is already answered for you.

Comments

[Duane Gran]

A few additional considerations:

1) Taxes are more likely to increase than decrease, in spite of the recent events. There are a dozen things pointing this way even if you support lower taxes or believe it is right. We're talking about government here.

2) If you have a Roth 401k option available it may be even a better option, as the income limits don't apply.

[Q at $1 Million to My Name]

It's impossible to predict what our tax rate is going to be 30-40 years from now. Just impossible. Go for the match first.

I personally prefer the Roth because it's at TDAmeritrade and I can trade stocks in the account.

[FMF]

Duane --

Good thoughts. I agree that tax rates are more likely to go up -- but do you think most individuals move up or down in tax brackets during retirement? My thought is that most people will move down in brackets (they earn less in retirement) so there may be a higher rate in place then for that level of income, but that bracket may still have a lower rate than the current bracket they're in. All of this would make the 401k a better deal, wouldn't it?

[Jonathan]

I'm usually right on board with your posts, but not quite sure about this one. Let me clarify.

1) I totally AGREE that the Roth IRA should be completely funded each year, if at all possible, first.
2) Beyond this, an IRA may be a cheaper way to invest. For example, my 401k institutes a 0.85% fee on the plan's assets, annually. So if you're invested in an index fund with a 0.5% expense ratio, you are guaranteed to underperform the market by 1.35% per year! A IRA from Fidelity, Vanguard, etc. offers an "almost" free way to let your retirement funds grow, assuming that low-expense funds are chosen and held for the long term.

[Jonathan]

I forgot to add to my comments above, that this excludes any sort of 401k company match.

My company doesn't ...:(

[Jeremy Bettis]

I think if you have to ask the question, then you are going to have so much money during retirement that you will be in the highest tax bracket, so go with the Roth.

I heard Dave Ramsey say that if you think you will have more than $750,000 in your IRA, then go with the Roth. But I must admit I don't understand why. He says that the manditory withdraws will push you into a higher tax bracket.

I you can do the Roth now, then you are in the 25% bracket or less (because of the Roth limit), but it seems that you would have to have 3 million in your IRA to hit the 28% bracket with manditiory withdraws only.

Here is a thought: With $750,000 in assets, and withdrawing 8% every year, that would be $60,000. That would almost put you in the 25% bracket with todays tax law. Maybe the idea is to use the Roth if your tax rate at retirement will be more OR THE SAME as they are now.

In any case, I am going to pack so much money away that I will be paying a lot more in taxes than I do now. Even if I never save another dime and just leave my IRA alone, it should be over $1,000,000 at age 65. (assuming 10% return)

[Terry]

We diversify our investments, why not diversify our type of savings? I primarily contribute to my 401K, but I also keep some in the Roth. That way I can withdraw money in a way that is most tax advantageous at the time.

[Jeffrey]

While there is only one answer mathematically, I have to say that this is "win-win." I have personally been saving in our 401k accounts to the match limit (6%) with each company, then saving in a Roth. I don't honestly know if I will be in a higher tax bracket or not. I think tax rates are likely to go up, and if they do, the Roth should be a better choice. However, even if tax rates don't go up, I can't honestly feel too bad that I "lost." I'm still much better off than if I spent the money.

[Duane Gran]

"[D]o you think most individuals move up or down in tax brackets during retirement?"

I think most people eke out a living on social security and the good will of family, but that is another matter. You are probably correct that most people will live on less income during retirement than during the prime working years. I brought up the matter of tax increases as a counter balance worth considering for the minority who are prodigious savers.

I like what another commenter said about diversifying investment modes. Tax law is certainly bound to change, but the Roth has several advantages when it comes to estate planning.

[Lord]

If you are seriously considering a Roth, you should consider investing outside of a retirement plan. You will have already paid taxes on your contribution. If you invest in low turnover indices, the incremental taxes on low dividends and capital gains are not that great, and when you do sell, you will be paying at capital gains rates rather than income tax rates.

[Peter L.]

OK, Here we go. This is my experience with a Roth IRA. Opened one with Fidelity in 1995. Just to see what they would do with it. Stock based. By 2002, it was down to $500. I get a call from Fidelity. Because my account is so low,I now must pay a fee for account administration or I can give them $1500 to get it back to $2000(minimum).SURE! I transfered it to mutual funds. It is now worth about $800 but the fees are making it disappear.If I take the money out I pay a huge fee and lose most of what`s left. If I had put the money in a jar I would have been better off. This is where most of America`s retirement money is?? Look out!!!

[Zook]

Sorry Peter, but that makes no sense.

You started with "fill in the blank" in 1995 and in 2002 it was at $500. You then transfered $1500 in the year "fill in the blank". Now in 2007 it's worth $800.

You think YOUR situation is common?

I'll reiterate, your gripe and story don't add up.

[Chris]

My situation (probably similar for most people) is that my 401k has very bad fund choices. I know I can beat the pants off my 401k return with my Roth IRA return because I can buy whatever funds or stocks that I choose. At the very best my 401k account will still not match the market return because of high expense ratios. Since starting my Roth I've been beating my 401k by 6-7%. This makes up for more than my employers 'free money' match.