Should I Contribute to a 401(k) or a Roth IRA?

by Sophia Bera on September 11, 2013

I am asked a lot of questions about retirement: Where should I save for retirement?  Should I use a 401(k) or a Roth IRA?  Can I do both?  What’s a Roth 401(k)?  How do I find out about my company match?  I have a 403(b), what’s that?  These are all great questions and today I want to break down the different ways to save for retirement and which one (or two) ways might be the best for your situation.

What’s the difference between a 401(k) and a Roth IRA?

A 401(k) is an employer sponsored retirement plan.  You make contributions through your paychecks and those contributions are deducted before your company takes out taxes.  (This is described as a “pre-tax” contribution).  A 403(b) is very similar to a 401(k) but this type of account is for employees of nonprofits and government agencies.

An IRA stands for Individual Retirement Account.  Therefore, you can have any type of IRA (Roth IRA, Traditional IRA, or Rollover IRA) at any brokerage firm and it is not tied to your employer.  When the word Roth is put ahead of IRA or 401(k) it means that you pay taxes on the contributions up front.  For example, you receive your paycheck and then you make a $200 contribution to your Roth IRA (you already paid taxes when you received your paycheck, therefore it is funded with after-tax dollars or “post-tax” contributions).

By contributing to a 401(k) today, you get a tax benefit this year and then your contributions grow tax free, but when you withdraw the money in retirement, you have to pay taxes on your distributions.  A Roth IRA works in the opposite way: you pay the taxes up front but then the money grows tax free and when you withdraw the money in retirement, you don’t have to pay taxes.

Take Advantage of Free Money

The best way to start saving for retirement is by taking advantage of your company match.  Some employers offer a company match and some don’t, but it’s worth calling up your Human Resources department or looking in your company benefits package to see what your company offers.  Always contribute at least enough to your 401(k) to get your full company match.  For example, if your company matches 50% of the first 6% percent, then you want to contribute at least 6% so you earn the 3% match.  This is one of the few times in life where you can get free money – don’t pass it up!

It All Comes Down To Taxes

Once you’re contributing enough to earn your full company match in your 401(k), then it’s time to look at your tax bracket.  The higher your tax bracket, the bigger tax benefit you receive in your 401(k).  So if you’re in the 35% tax bracket then you’ll probably want to contribute the maximum to your 401(k), which is $17,500 per person, per year for 2013.  If you earn $200,000 but contribute $17,500 to your 401(k) then you’ll only pay taxes on $182,500.  However, if you’re in a lower tax bracket like the 15% or 25% bracket, then you might want to contribute to a Roth IRA, especially if you think you’ll be in a higher tax bracket in the future.  Since you fund your Roth IRA with after tax dollars, you may be better off contributing to your Roth IRA now and then you won’t have to pay taxes when you withdraw the money from your Roth IRA in retirement.  If your company doesn’t offer an employer match on your 401(k), you might want to skip it and head straight for the Roth IRA.  You can contribute a maximum of $5,500 per year to a Roth IRA for 2013.

Can Anyone Contribute to a Roth IRA?

No.  You have to have earned income.  For example: if you are a full-time student and you don’t have a job, then you can’t contribute to a Roth IRA.  (Unless your spouse has earned income, in which case, you may qualify).  Also, there are income limits in order to qualify.  If you are single and you make more than $127,000, you don’t qualify to make Roth IRA contributions.  If you are married and make more than $188,000, you and your spouse make too much money to qualify for Roth IRA contributions.  (This number is based on your Modified Adjusted Gross Income (MAGI) which you can find on your tax return).

I’m Gen Y.  Isn’t it always best to contribute to a Roth IRA?

Not necessarily.  Some people make the argument that tax brackets will be higher in the future so if you’re young you should always contribute to a Roth IRA or Roth 401(k) because you will pay more in taxes later, but we don’t really know what tax rates will be in the future.  I think that having some tax-deferred money (in a 401(k) or IRA) and some money in a Roth is a good thing because it will allow you to have different “tax buckets” in which to pull your money from in retirement.  The higher your tax bracket the more I encourage you to contribute to a 401(k) whereas if you’re in a lower tax bracket, I highly encourage you to contribute to a Roth IRA.

Don’t Wait!  Just Start!

The biggest error I see Gen Y make is to wait to start saving for retirement.  Some people won’t start a Roth IRA because it takes more effort to open the account and it’s easier for them to just sign up for their 401(k).  If that’s you, then do that!  Sign up for your 401(k) today!  If you’re already contributing, then increase your contributions by 1% today!  What are you waiting for?  Small changes add up to big results over time.  Just start! 

 

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