Roth IRA vs. 401(k): Which Plan Has the Advantage?

By Clifton Linton
Senior Writer, mPower

In this article: Employer-Matched 401(k) Beats Roth IRA Cliff's Napkin Notes Roth IRA Pulls Even With No 401(k) Match Taxes Now, Or Later? How To Hedge Your Bets Roth IRA: Too Good To Be True? Other factors

Sui Ming Louie, a 33-year old structural engineer, knows how to build sturdy bridges and buildings.

But, he feels his 401(k) plan is a little shaky. He doesn't feel he can lay down a large enough foundation for his future. If he had the chance to design his own solidly built retirement plan he would design it so he could contribute more money each year.

His employer lets him contribute 15% of his salary to the plan. At his current salary, Louie can't stash away the $10,000 annual maximum contribution allowed by law.

He's trying to get his company to change its plan. "I'm still in a debate with them," he said.

Like many Americans looking to boost their retirement savings, Louie has also opened a Roth IRA. Into that he shovels the maximum allowed, $2,000 a year.

It's a good idea that has the added benefit that when Louie taps that money at retirement, he won't have to pay any taxes on the gains.

401(k) Advantages and Disadvantages Advantages: Contributions lower your current gross income Maximum contribution of $10,000 a year Most employers pay plan administration fees You can borrow from the plan Automatic payroll deduction Disadvantages: You pay deferred tax at retirement Limited investment choice Penalties for early withdrawal (before age 59˝ or, in some cases, 55)

And there's the rub. Many employees see the Roth IRA's tax advantage over the 401(k) plan and wonder if they should just give up on the 401(k) plan entirely. Indeed, quite a rift has developed in the financial planning community over whether a Roth IRA's tax advantages mean you should give up on a 401(k) plan.

The decision boils down to trade-offs. This article presents some general guidelines in choosing between the two. However, you probably want to consult with a financial planner to develop the best strategy for yourself. Many of the calculations used to compare the two plans are very complex.

Don't be itchy to pull the plug on your 401(k) plan, because experts we interviewed say it has a lot going for it.

Employer-Matched 401(k) Beats Roth IRA

"The 401(k) plan, in most cases, gives the opportunity for (employer) matching contributions. That's something a Roth doesn't offer." - Stephen Cohn, financial planner

If you have a 401(k) plan with a company match there's just no way a Roth IRA can keep up. Stick with the 401(k) plan.

"The 401(k) plan, in most cases, gives the opportunity for (employer) matching contributions. That's something a Roth doesn't offer. That has a significant effect on the accumulation of assets," said Stephen Cohn, financial planner and cofounder of Sage Online, a financial services firm.

This writer sat down at a 401Kafé table with Ted Benna, who ran a few scenarios through yield calculators that prove Cohn correct, and sketched the results on a paper napkin, below.

"Cliff's Napkin Notes"

Let's suppose a 25-year old sets aside $2,000 into a traditional IRA, a Roth IRA and a 401(k) with a 50% company match. Also assume a 10% annual return and a 25% tax rate.

By age 65, the money in the traditional IRA will have grown to $90,000, but when the tax is paid on the gains, the net proceeds are $68,000. The $2,000 in the Roth IRA will reach $90,000 in 40 years and that money is available tax-free. The $2,000 in the 401(k) plan will grow to $135,000, and after taxes, the net proceeds are $101,000.

To be entirely fair, you should realize that the $2,000 contributed to a traditional IRA was made on a pre-tax basis. Let’s assume for a minute you wanted to contribute that same $2,000 to a Roth, you would pay $500 in taxes, assuming a 25% tax rate. Your initial investment would in that case be $1,500 and over 40 years grow to about $68,000, comparable to a traditional IRA.

For the example above, we assume a $2,000 investment regardless of the present tax consequences. As you can see, the 401(k) plan with a match still wins out over the IRA options.

Keep in mind that federal law lets you contribute as much as $10,000 annually to a 401(k) plan. However, the maximum-allowed contribution to a Roth IRA is $2,000 a year.

Roth IRA Pulls Even With No 401(k) Match

When you don't have a company match, the Roth IRA starts to gain on the 401(k) plan, says Hubert Forcier, a partner with Minneapolis law firm Faegre & Benson LLP.

"Testing an unmatched contribution of a 401(k) versus a Roth, you can get an advantage for the Roth," he said.

Indeed, $2,000 in a 401(k) plan without an employer match will grow like a traditional IRA plan. That $2,000 would grow to $90,000 and after taxes be worth $68,000.

But, he points out this tax advantage could be fleeting. "You could get either one to be better, depending on the relative tax rate you use. It's hard to know what your tax rate will be in retirement," he said.

Figuring out your tax liability is one of the more complicated variables and a leading reason to get a professional's advice.

Suppose you don't have a company match? There still may be a reason to stick with your 401(k) plan: you're allowed to save more in it than a Roth IRA. If you could contribute the full $10,000 a year to a 401(k) plan, even after taxes, you'll be far ahead of a Roth IRA.

Taxes Now, Or Later?

If you contribute to a Roth IRA, now, you don't get any up-front tax benefit. You pay taxes on the money before it goes into the plan. But at retirement time, you can withdraw your principal and all profits tax-free and penalty-free, provided you have had the account for at least five years.

"I would love, when I'm 65 and drawing down retirement income to have a significant chunk of money in a Roth IRA. That way some money would be fully taxable and some wouldn't," said Ted Benna, the creator of the first 401(k) plan.

Having a Roth IRA could give you more flexibility to take early retirement, Benna says. With a 401(k) plan, the first time you can get at your money without paying a 10% early withdrawal penalty is age 55.

If you save in a 401(k) now, that will reduce your current gross income. A lot of people have higher income in their working years than in their retirement years. So, it's important to lower their adjusted gross income, currently.

The drawback with a 401(k) plan is you pay the taxes when you start to withdraw the money at retirement. But if you're earning less income and therefore fall into a lower tax bracket, the tax bite won't be as big.

How To Hedge Your Bets

"Maybe you should hedge your bets. Go one year Roth IRA and one year 401(k)." - Hubert Forcier, employee benefits attorney

For those wanting the best of both worlds, try hedging your bets Forcier suggests. "Go one year Roth and one year 401(k)," he urges. "Now you've taken care of the tax structure."

If you have the money available, you could also consider contributing to both plans. If you have a 401(k) your ability to make tax-deductible contributions to a traditional IRA may be limited, depending on your income. But you can make after-tax contributions to a traditional IRA no matter how high your income, or contribute to a Roth IRA if you meet the income limit for Roths.

Again, if you have a 401(k) plan with a company match, that's too good of a benefit to pass up. "It makes sense to do the maximum in a 401(k) matched by the company," Benna said.

Roth IRA: Too Good To Be True?

If you want to open a Roth IRA, you better do it quickly. The reason: A tax break like this is almost too good to be true, Benna says.

"If we get back into a situation where (Congress is) scrambling for money, then the Roth IRA tax break is suspect," he said.

That means if Congress needs more money, at the least it might not allow employees to open any new Roth IRAs, Benna says. That shouldn't impact existing Roth accounts. But, if Congress were really tight on money, the entire tax break could be repealed, Benna warned.

Indeed, that's the reason why Louie is trying to get his company to change its plan. "The only reservation I have is that the Roth can be repealed. I don't know what the government will do," he said.

The operating logic here is: What Congress giveth, Congress can taketh away.

Other factors

One advantage of the 401(k) is forced saving. You don't have to think about it. Your employer automatically deducts the money from your paycheck. "The reality is that most of us don't stick to a (savings) program unless it's taken out of our paycheck every pay period," Benna said.

An advantage of the Roth IRA is that you can withdraw money before retirement without penalty. But, there are a few catches. First, the account must be open five years. Second, the penalty-free withdrawal applies only to the account's principal. (Click Here to see related story for Roth IRA distribution rules.)

"The Roth rules allow you to remove the principal with no tax," said Noelle Allen, a certified public accountant and chairwoman of the California CPA Society committee on tax. "If the money is in a 401(k) you can't take (it) out tax free."

However, unlike a 401(k) plan, you can't take a loan from your Roth IRA (or a traditional IRA for that matter). But you can take out money for a first-time home purchase without penalty. Unlike a 401(k) plan you aren't required to pay back your Roth or traditional IRA account.

You may have more investment choices with a Roth IRA than a 401(k). Often employers limit the number of investment choices you have in a 401(k) plan. Not so with a Roth IRA. If you open a Roth at a fund supermarket, you may have hundreds if not thousands of funds to choose from.

"You might conclude you could get a higher rate of return with a Roth with more choices," Forcier said.

But, there could be a drawback to the Roth in the form of higher administrative fees. A majority of employers pick up the cost of administrative fees with 401(k) plans. In 1998, about 82% of companies picked up legal and plan design fees, and 62% picked up plan record keeping fees, says the Profit Sharing/401(k) Council of America. A minority of plans, 26.9%, pick up the costs of investment management fees.

You pay all the administrative and investment management fees with a Roth IRA.

Another drawback with the Roth IRA is that there's an income cap. If you were married and filed a joint return and earned more than $160,000 you could not open one. The same would be true if you were a single head of a household and earned more than $110,000.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Roth IRA vs. 401(k): Which Plan Has the Advantage?

By Clifton Linton
Senior Writer, mPower

In this article: Employer-Matched 401(k) Beats Roth IRA Cliff's Napkin Notes Roth IRA Pulls Even With No 401(k) Match Taxes Now, Or Later? How To Hedge Your Bets Roth IRA: Too Good To Be True? Other factors

Sui Ming Louie, a 33-year old structural engineer, knows how to build sturdy bridges and buildings.

But, he feels his 401(k) plan is a little shaky. He doesn't feel he can lay down a large enough foundation for his future. If he had the chance to design his own solidly built retirement plan he would design it so he could contribute more money each year.

His employer lets him contribute 15% of his salary to the plan. At his current salary, Louie can't stash away the $10,000 annual maximum contribution allowed by law.

He's trying to get his company to change its plan. "I'm still in a debate with them," he said.

Like many Americans looking to boost their retirement savings, Louie has also opened a Roth IRA. Into that he shovels the maximum allowed, $2,000 a year.

It's a good idea that has the added benefit that when Louie taps that money at retirement, he won't have to pay any taxes on the gains.

401(k) Advantages and Disadvantages Advantages: Contributions lower your current gross income Maximum contribution of $10,000 a year Most employers pay plan administration fees You can borrow from the plan Automatic payroll deduction Disadvantages: You pay deferred tax at retirement Limited investment choice Penalties for early withdrawal (before age 59˝ or, in some cases, 55)

And there's the rub. Many employees see the Roth IRA's tax advantage over the 401(k) plan and wonder if they should just give up on the 401(k) plan entirely. Indeed, quite a rift has developed in the financial planning community over whether a Roth IRA's tax advantages mean you should give up on a 401(k) plan.

The decision boils down to trade-offs. This article presents some general guidelines in choosing between the two. However, you probably want to consult with a financial planner to develop the best strategy for yourself. Many of the calculations used to compare the two plans are very complex.

Don't be itchy to pull the plug on your 401(k) plan, because experts we interviewed say it has a lot going for it.

Employer-Matched 401(k) Beats Roth IRA

"The 401(k) plan, in most cases, gives the opportunity for (employer) matching contributions. That's something a Roth doesn't offer." - Stephen Cohn, financial planner

If you have a 401(k) plan with a company match there's just no way a Roth IRA can keep up. Stick with the 401(k) plan.

"The 401(k) plan, in most cases, gives the opportunity for (employer) matching contributions. That's something a Roth doesn't offer. That has a significant effect on the accumulation of assets," said Stephen Cohn, financial planner and cofounder of Sage Online, a financial services firm.

This writer sat down at a 401Kafé table with Ted Benna, who ran a few scenarios through yield calculators that prove Cohn correct, and sketched the results on a paper napkin, below.

"Cliff's Napkin Notes"

Let's suppose a 25-year old sets aside $2,000 into a traditional IRA, a Roth IRA and a 401(k) with a 50% company match. Also assume a 10% annual return and a 25% tax rate.

By age 65, the money in the traditional IRA will have grown to $90,000, but when the tax is paid on the gains, the net proceeds are $68,000. The $2,000 in the Roth IRA will reach $90,000 in 40 years and that money is available tax-free. The $2,000 in the 401(k) plan will grow to $135,000, and after taxes, the net proceeds are $101,000.

To be entirely fair, you should realize that the $2,000 contributed to a traditional IRA was made on a pre-tax basis. Let’s assume for a minute you wanted to contribute that same $2,000 to a Roth, you would pay $500 in taxes, assuming a 25% tax rate. Your initial investment would in that case be $1,500 and over 40 years grow to about $68,000, comparable to a traditional IRA.

For the example above, we assume a $2,000 investment regardless of the present tax consequences. As you can see, the 401(k) plan with a match still wins out over the IRA options.

Keep in mind that federal law lets you contribute as much as $10,000 annually to a 401(k) plan. However, the maximum-allowed contribution to a Roth IRA is $2,000 a year.

Roth IRA Pulls Even With No 401(k) Match

When you don't have a company match, the Roth IRA starts to gain on the 401(k) plan, says Hubert Forcier, a partner with Minneapolis law firm Faegre & Benson LLP.

"Testing an unmatched contribution of a 401(k) versus a Roth, you can get an advantage for the Roth," he said.

Indeed, $2,000 in a 401(k) plan without an employer match will grow like a traditional IRA plan. That $2,000 would grow to $90,000 and after taxes be worth $68,000.

But, he points out this tax advantage could be fleeting. "You could get either one to be better, depending on the relative tax rate you use. It's hard to know what your tax rate will be in retirement," he said.

Figuring out your tax liability is one of the more complicated variables and a leading reason to get a professional's advice.

Suppose you don't have a company match? There still may be a reason to stick with your 401(k) plan: you're allowed to save more in it than a Roth IRA. If you could contribute the full $10,000 a year to a 401(k) plan, even after taxes, you'll be far ahead of a Roth IRA.

Taxes Now, Or Later?

If you contribute to a Roth IRA, now, you don't get any up-front tax benefit. You pay taxes on the money before it goes into the plan. But at retirement time, you can withdraw your principal and all profits tax-free and penalty-free, provided you have had the account for at least five years.

"I would love, when I'm 65 and drawing down retirement income to have a significant chunk of money in a Roth IRA. That way some money would be fully taxable and some wouldn't," said Ted Benna, the creator of the first 401(k) plan.

Having a Roth IRA could give you more flexibility to take early retirement, Benna says. With a 401(k) plan, the first time you can get at your money without paying a 10% early withdrawal penalty is age 55.

If you save in a 401(k) now, that will reduce your current gross income. A lot of people have higher income in their working years than in their retirement years. So, it's important to lower their adjusted gross income, currently.

The drawback with a 401(k) plan is you pay the taxes when you start to withdraw the money at retirement. But if you're earning less income and therefore fall into a lower tax bracket, the tax bite won't be as big.

How To Hedge Your Bets

"Maybe you should hedge your bets. Go one year Roth IRA and one year 401(k)." - Hubert Forcier, employee benefits attorney

For those wanting the best of both worlds, try hedging your bets Forcier suggests. "Go one year Roth and one year 401(k)," he urges. "Now you've taken care of the tax structure."

If you have the money available, you could also consider contributing to both plans. If you have a 401(k) your ability to make tax-deductible contributions to a traditional IRA may be limited, depending on your income. But you can make after-tax contributions to a traditional IRA no matter how high your income, or contribute to a Roth IRA if you meet the income limit for Roths.

Again, if you have a 401(k) plan with a company match, that's too good of a benefit to pass up. "It makes sense to do the maximum in a 401(k) matched by the company," Benna said.

Roth IRA: Too Good To Be True?

If you want to open a Roth IRA, you better do it quickly. The reason: A tax break like this is almost too good to be true, Benna says.

"If we get back into a situation where (Congress is) scrambling for money, then the Roth IRA tax break is suspect," he said.

That means if Congress needs more money, at the least it might not allow employees to open any new Roth IRAs, Benna says. That shouldn't impact existing Roth accounts. But, if Congress were really tight on money, the entire tax break could be repealed, Benna warned.

Indeed, that's the reason why Louie is trying to get his company to change its plan. "The only reservation I have is that the Roth can be repealed. I don't know what the government will do," he said.

The operating logic here is: What Congress giveth, Congress can taketh away.

Other factors

One advantage of the 401(k) is forced saving. You don't have to think about it. Your employer automatically deducts the money from your paycheck. "The reality is that most of us don't stick to a (savings) program unless it's taken out of our paycheck every pay period," Benna said.

An advantage of the Roth IRA is that you can withdraw money before retirement without penalty. But, there are a few catches. First, the account must be open five years. Second, the penalty-free withdrawal applies only to the account's principal. (Click Here to see related story for Roth IRA distribution rules.)

"The Roth rules allow you to remove the principal with no tax," said Noelle Allen, a certified public accountant and chairwoman of the California CPA Society committee on tax. "If the money is in a 401(k) you can't take (it) out tax free."

However, unlike a 401(k) plan, you can't take a loan from your Roth IRA (or a traditional IRA for that matter). But you can take out money for a first-time home purchase without penalty. Unlike a 401(k) plan you aren't required to pay back your Roth or traditional IRA account.

You may have more investment choices with a Roth IRA than a 401(k). Often employers limit the number of investment choices you have in a 401(k) plan. Not so with a Roth IRA. If you open a Roth at a fund supermarket, you may have hundreds if not thousands of funds to choose from.

"You might conclude you could get a higher rate of return with a Roth with more choices," Forcier said.

But, there could be a drawback to the Roth in the form of higher administrative fees. A majority of employers pick up the cost of administrative fees with 401(k) plans. In 1998, about 82% of companies picked up legal and plan design fees, and 62% picked up plan record keeping fees, says the Profit Sharing/401(k) Council of America. A minority of plans, 26.9%, pick up the costs of investment management fees.

You pay all the administrative and investment management fees with a Roth IRA.

Another drawback with the Roth IRA is that there's an income cap. If you were married and filed a joint return and earned more than $160,000 you could not open one. The same would be true if you were a single head of a household and earned more than $110,000.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.