Help a Reader: 401k vs. Roth

Here's an email I recently received from a reader:

My company just announced a series of changes they are making to our benefits, including our 401(k) plan. Currently, they match $0.50 on the dollar up to 3% of your annual salary (so, if you contribute 6%, they kick in 3%), and they do this with every paycheck. They are now changing this from contributing every paycheck to only contributing once in a lump sum at the end of the year. The amount stays the same, but the timing changes, so I feel like I will be losing out on any gains I may make during the year. (In addition, if you leave the company prior to the end of the year, you forfeit the match for the year.)

I had been contributing 8% of my salary to the 401(k), with an automatic 1% yearly increase. I don't currently have a Roth IRA, but had planned to start one this year. My question is whether the matching contribution change makes it more attractive for me to put more money into the Roth and just put enough into the 401(k) to get the full match, or, since I already have a fair amount in the 401(k), should I continue to increase my contributions to that and just put what I can into the Roth?

What's your advice for him?

Comments

[John S @ Frugal Rules]

I hate reading the employers are doing this and think it'll just continue as time goes on. Is this person able to max out their Roth if they only contribute the amount needed to get the match? If they are & depending on what options they have in the 401k it might be better to shift it to the Roth...max it out and put the funds in over the year.

[Matt]

Put the minimum enough money into the 401k to get the match. Contribute to a Roth until the max. Then save the rest back in the 401k to your maxium level you can.

It will be wise to plan on having different sources of income to draw upon in retirement. The 401k money is pre tax and will be taxed when withdrawn it while the Roth is post tax and as right now will not be taxed when withdrawn.

You can vary your tax burden on which pot of money you cash in.

[JP]

He could counteract the "lost gains" by contributing in a lump sum at the beginning of the year.

[Money Beagle]

I don't think the effect of the lump sum is going to be that huge. Even if it's $2,000 and the market goes up 10%, you're only looking at around $100 you're losing out on, which is significant but probably isn't going to alter your retirement date.

We have no company match so I guess I can't empathize too much :)

[Brent]

You really should have only been putting in the max amount that your company will match you and then maxing out a ROTH IRA this entire time, so consider this a wake up to make a change.

Your ideal situation is to max out the match you will get through employer 401k, max out your ROTH IRA and then if you have additional money, put that in the 401k.

This gives you a little bit of tax diversification and not putting all of your eggs in one basket. If you are not disciplined enough to put your own money into a ROTH IRA, keep on doing what you are doing and putting as much as possible into your 401k. Anything saved is better than nothing saved!

[Kurt @ Money Counselor]

If you can afford it, put the max allowed by law into each of the 401k and IRA. If you can't, I'd do these steps, in this order:

1. Contribute enough to the 401k to get the full match
2. Contribute to a IRA, up to the max allowed by law
3. Contribute more to the 401k, up to the max

[Apex]

The change in when the match occurs has zero impact on whether or not you should switch some of your funds to a Roth IRA.

You did not provide the necessary information to answer the question. It depends on your tax bracket now and your future expected tax bracket. Knowing your age now and future expected earnings is also important. For example, if you are in a low tax bracket now but expect to be in a higher one in 5 years, you should likely switch to the Roth now and come back to the 401-k later. However if you are in a high bracket now then going to the Roth now may be a mistake especially if you expect to have a lower bracket in retirement.

Without that kind of information, any advice given is just based on people's personal preference for one vehicle over the other but there can't be a very informed answer without that information.

[JNEW]

As usual, the answer to this question has numerous variables and requires the investor to make certain assumptions.There is no right answer for everyone.

1. Do you trust that the government will keep its promise not to tax the money you take out of the Roth IRA? (I don't-- they previously stated that social security would not be taxed....) If you agree with me-- it might be wise to invest more in the 401k and take the deduction now rather than forego the deduction and have your money taxed anyway.

2. Is your tax bracket high enough at this time so that a deduction is beneficial to you?

3. Do you think that your tax bracket during retirement will be higher than it is now? If yes-- prioritize a Roth. If not-- prioritize the 401K.

4. Do you think it is beneficial, as others have stated, that you should put some money in each of the two retirement vehicles so that you might have option upon withdrawal? (I do).

Sorry to be so "fuzzy", but the right decision for you depends on your assumptions as to what the future landscape will look like. Educate yourself on the options, the pros and cons-- and then do what you think is best based on your thought process.

[Mrs PoP @ Planting Our Pennies]

I'd do 401K up to match, then Roth IRA, and then back to 401K after Roth was maxed out. Though the contributions to the 401K are really premised on the fact that he expects to stay worth the company through the end of the year And through the vesting period. If his 401K options are bad and he doesn't expect to stay there, it might make sense to start saving elsewhere (especially if he has a side gig and can open an self employment IRA or 401K).

[M]

As an employee, its just annoying that a company would make this change.

However, Moneybeagle is correct, the actual $ amount of the impact is very small (10% of 3% of salary, divided by 2.....because it assume the money is there on average of only 6 months). The bigger issue would be in the year you leave the company, where you would lose all match.

In the even that you do work for the big and famous IT company that just made a similar change (which hit the major papers), you should still recognize the 401k is excellent. The fund choices are top notch, and the fees are excellent (Total Stock Index @ 0.04%). Moreover, they offer a Roth version on their 401k which has greater max than IRA, and still gets the employer match (non-Roth).

So overall, this change is annoying, but you probably shouldn't make dramatic changes to your personal strategy because of it.

[Adam]

Mathematically speaking, if you are currently deciding between contributing 8% or 6%, the change the company is making is irrelevant. Either way, the company still lump sums 3% to you at the end of the year.

[Luis]

That you talk about Roth IRA makes the assumption that you are Roth eligible and have an income that makes the Roth an ideal choice for you. Before you move on the Roth IRA suggestion you should check into the tax ramifications. As others have mentioned your expected tax bracket is important and so lets run an example.

Let's say you are married, your joint MAGI (with 401k contribution up to the matching) is around 75k, and you have an extra 5k in savings that could go either into a Roth or into additional 401k. If the lower limit of the 25% bracket for 2013 remains near the 70k for 2012, you'd be better off investing that 5k in the 401k. By doing so your income would be taxed completely at or below 15% and i think you would find that very difficult to beat in retirement.

[Luis]

In most cases you will find that the Roth wins out unless you are within 10k at the lower end of the tax bracket as per the example above and/or expect to be at a lower tax bracket in retirement.

[Young Limey]

I complety agree with Kurt's priority response.

Keep pushing yourself until all 3 steps are complete. When you are on step 3, 1% additions to 401k seem small, I bet you could push yourself to add 3-5% more each year.

[Apex]

@Luis,

I am a bit confused by your two posts. You seem to be arguing that if he is at the margins and can lower his bracket then he should do the 401k but otherwise do the Roth. Is that what you are saying?

So let's say his taxable income is 100K. In that case regardless of what he does he is going to have some of his income taxes at the 25% bracket. So if he contributes 5K extra to a Roth instead of a 401k he will pay an extra $1250 in tax. But that is also true if his income is 75K.

You seem to be saying if you are already going to be paying some at 25% anyway might as well just pay more at 25%. There may be an emotional allure to keeping all the money in the 15% bracket but the fact that all of his other money would be taxed at 15% if he was at the margin does not change the calculations. It still comes down to tax bracket paid now versus later and the tax bracket he is saving on is the 25% bracket whether he is at 75K or 100K. Now if he was at 75K there could be a strong case for 5K to the 401-k and the rest to the ROTH because it changes the tax bracket. But if you are only putting in 5K either way then 75K or 100K the math is the same.

If you believe differently I would be interested to see the math.

[jim]

Apex is right. The question about whether you should put money in a Roth or 401k (above the match) is dependent on your tax bracket now and later and your retirement plans.

Adam is right. The change in question is irrelevant.
The change from paycheck contributions to lump sum really shouldn't matter here.

You want to contribute to the 401k to get the full match from the employer. THe change to lump sum only changes how the employer match is paid. It won't impact your other investments to 401k or Roth. You want to get that full employer match since its free money.

There are MANY situations where a Roth isn't the best choice and many others where its the best choice. Theres no black and white rule of thumb answer here sorry.

[Bryan B]

That's pretty lame that your employer is waiting for a lump sum match. Not just for lost opportunity cost but it just smells like an accounting trick to hide something!

Agree with Apex and everyone else that your tax bracket should be the main factor. I just recently stopped contributing to my Roth IRA and Roth 401k and now doing all my retirement savings into my Traditional 401k because I got a big pay bump and moved from a 0% income tax state to a very high income tax state.

[Sam]

401k until the match ends - timing doesn't matter, it's still the best return available to you.
Roth up until the limit.
Tax bracket/now later doesn't tell the whole story, the fees inside your 401k are usually much higher than you can achieve in a self directed Roth IRA and you will come out ahead in the Roth even with a delta in tax brackets. Roths are far more flexible in terms of timing when you take money out.

[Strick]

"I don't currently have a Roth IRA"

I think the only easy part of this is to open and somewhat fund a Roth. As everyone discusses, it comes down to comparisons of tax brackets between now and future (both your income changes and tax changes). Given you don't know the future, its a lot of guessing as to how much to put in each, but I can tell you its a slam dunk that you do want some of pre-tax and post-tax retirement accounts and non-retirement accounts so you have options later. Except for RMDs (which are quite small), you really are in control of what gets taxed, when and how.

[Rich Guy]

Max out the match you will get through employer 401k, max out your ROTH IRA and then if you have additional money, put that in the 401k.

My wife's employer just announced the same policy of a year end match with no match if you leave. That is a clear DECREASE in benefits and pisses me off.

[Luis]

@ Apex

Sorry for the delayed response but I was out on vacation last week.

I may not have been clear with my explanations but I think we are saying the same thing in regard that there could be a strong case for putting 5k of available savings into a 401k rather than a ROTH if he were at 75K.

The Roth in most other instances is an excellent vehicle and its many benefits draw greater interest from the average investor even beyond tax bracket comparisons. I could list some tangibles but am afraid I'd miss some of its many benefits. Plus there are plenty of information out there already for one to research the ROTH to see if it is right for them.