I’m sorry for the click-bait title that might be a little bit misleading. But you’re here aren’t you? That’s what’s important. I believe strongly in saving for retirement – as much as possible and as early as possible. But I prefer to use a Roth IRA instead of a 401(k) to do so.
Background
Even if you know very little about retirement savings, you’re probably familiar with the term 401k. Whenever I talk to my friends about retirement, they pretty much say, “I don’t know a lot about retirement stuff but I have a 401k.” It’s better than nothing but usually they don’t really know what a 401k does or what other options are available to them. They simply opted into their company’s plan.
I will go over the main differences between a 401k, IRA, and Roth-IRA – all of which are tax advantaged retirement saving vehicles.
It’s important to note that these are my own opinions and you should do more research of your own before making any financial decisions.
I opened a Roth-IRA retirement account when I turned 18. Yes, that was in high school. I had just learned about the magic of compound interest and I wanted to start saving as soon as possible even if it was just a small amount. Time is the greatest advantage you have when it comes to retirement saving.
The main reason to put money into a dedicated retirement account v.s. just leaving it in the bank or using another investment tool is the tax advantage. All retirement vehicles have some sort of tax advantage – 401k, IRA, and Roth-IRA. There are more options available including a Roth 401k, but these three are the most common.
A 401k account is tied to an employer, while any individual can open an IRA or Roth IRA. Here’s a quick guide to the main benefits of each:
- 401k: Pay taxes upon withdrawal, grows tax free
- IRA: Pay taxes upon withdrawal, grows tax free
- Roth IRA: Pay taxes up front, grows tax free
All three of these retirement vehicles grow tax free which is important. You won’t pay capital gains tax as you do in a traditional investment account.
But you still have to pay some taxes. And the big difference between the three is when you pay taxes. When you contribute to a 401k or traditional IRA, your contributions lower your taxable income so you get a small tax break up front.
For example, if you make $50,000 per year and contribute $5,000 to your 401k or IRA, your taxable income for the year would be $45,000 thus lowering your tax bill. Since you paid no taxes on your contributions today, that means you will have to pay taxes when you eventually take the money out of that retirement account.
On the other hand, contributions to a Roth IRA do not lower your taxable income. If you make $50,000 per year and contribute the same $5,000 to a Roth IRA, your taxable income is still $50,000. However, this means that you don’t have to worry about paying taxes when you withdraw the money since you got no up front tax break.
There are also contribution limits for each that you can look into on your own. For most millennials, the lower IRA limits won’t be a concern.
401k Employer Matching
I strongly believe in using a Roth IRA over a 401k and I’ll explain why next, but here’s one caveat before I do. If you work for a company that offers a great 401k matching plan, contribute the max amount that will be matched there first. Why? Because it’s FREE money and it’s not often that there are opportunities to get free money.
Always read the fine print when choosing funds. I recommend putting all or the large majority of your contributions into the lowest-fee option. If there isn’t a low cost index fund, consider asking your employer to add one in. You can reference my prior blog post here for more info on why low fees are extremely important to your investment strategy.
If you are able to contribute more than your maximum employer match, then I recommend opening your own Roth IRA and contributing any additional funds there. You can very easily open your own Roth IRA account with Wealthfront.
Benefits of a Roth IRA:
1. Limit Uncertainty
When you contribute to a Roth IRA, you use post-tax income, meaning your contributions don’t lower your taxable income as with a 401k. You know what tax bracket you’re in right now, but do you know what tax bracket you’ll be in come retirement age?
For the large majority of middle class Americans, the tax break they will receive now from 401k contributions will be very small and not noticeable. You’ll likely be in a higher tax bracket at retirement meaning you’ll have to pay more taxes when you take your money out than if you paid them upfront. The future is uncertain, especially if you’re 30+ years away from retirement. I would rather know what I pay now than take an unnecessary gamble.
If you’re very close to retirement age (say 5-10 years away) or you’re in a very high tax bracket (good for you!), then this blog post is not for you. This advice is for the large majority of Americans who make a middle class income and for readers of my blog who are mostly decades away from retirement age. I don’t believe that the minuscule and likely unnoticeable tax benefit now is worth all of the other pretty significant downfalls of 401ks. An online tax calculator could be helpful as you consider different retirement vehicles.
2. Simplicity
When it comes to any type of investing, simple is often the best. You won’t need to hire a CPA to help you figure out how much you owe in taxes. When you’re 70 years old and likely a little less sharp, you’ll know that all the money in your account is yours, free and clear. If you have a million dollars in your Roth-IRA, then you have a million dollars. If you have a million dollars in a 401k, you actually have a lot less than that and you may need to hire someone to help you figure out how much you owe the tax man. Avoiding that headache in old age seems worth any smaller up-front tax break.
3. Freedom
I don’t like it when the government tells me what to do with my money. 401ks and traditional IRAs both have something called Required Minimum Distributions (or Withdrawals) and it’s exactly what it sounds like. When you reach age 70, the government says “hey, it’s time to take our share of your retirement savings.” Because remember, you haven’t paid any taxes yet with a 401k or IRA. Maybe you’re still working part-time or have savings in other places and you don’t want to touch your 401k yet. Too bad. You’ll be forced to withdraw about 3-4% from your account each year and of course pay taxes on those withdrawals.
On the other hand, there are zero required withdrawals for Roth IRAs because you already paid taxes up front! You can leave the money there until you die or take it out as you please, all without having to calculate taxes. It’s all yours.
No matter what retirement vehicle you choose, I always recommend choosing low cost index funds as the bulk of your portfolio. A Random Walk Down Wall Street is a great book that will teach you everything you need to know about investment strategy – whether in your retirement account or elsewhere.
Conclusion
After maxing out employer matching, a Roth IRA provides considerable long-term benefits over a traditional 401k or IRA. The small tax benefit you receive today is probably not making a big difference in your life but the tax consequences of a 401k could be significant in old age.
I hope this information is helpful and will lead you to do your own research and maybe even form a different opinion than mine. Retirement should take more thoughtful consideration than simply opting into an employer plan.
