What’s Better – 401(k) Or Roth IRA?

One of the most frequently asked questions planners get about retirement planning is what’s better for retirement planning: a 401(k) or a Roth IRA. The answer may not be as straightforward as it might seem.

Under section 401(k) of the IRS code, a 401(k) is an employer-sponsored deferred contribution plan for retirement. In your workplace, you set up a 401(k) plan with human resources and choose options within the defined plan. Your employer takes money out of your paycheck prior to income taxes being taken out and deposits this into your 401(k) plan. Some employers even match your contributions. When you retire, you can decide to withdraw money out of the 401(k), but those withdrawals are subject to income tax when they are taken out 10,20, 30 years later. Currently, there are no income limitations on who can contribute, but an individual can contribute at most $15,500 to their 401(k) in 2008. $46,000 is the maximum aggregate amount that can be contributed between employer and employee in 2008.

Senator William Roth was the chief sponsor of this movement. A Roth IRA is an individual retirement account independent from your employer that you create directly with a custodian firm. After a Roth IRA account is set up, these plans have a much wider investment selection typically, and then directly deposit after-tax money from your checking account into the Roth IRA. Then, after meeting you turn 59 1/2 years old and have had the plan for at least five years, you can withdraw from the account entirely tax free. In 2009, the maximum you can contribute is $5,000 a year (unless you’re over 50). There is one big qualification: if you make more than $99,000 individually or $156,000 as a married couple, you cannot contribute the full amount (and may not be able to contribute at all).

The largest differences between the two plans are workplace contributions, investment options/management, and taxes. Let’s walk through each feature.

Employers with a 401(k) retirement plan may or may not match contributions made by an employee. For example, a 401(k) program may offer a 50% match for every dollar the employee contributes to a 401(k) up to 4% of the salary. Therefore, if the employee contributes 4% of their salary to their 401(k), the employer also puts in an extra 2% of your salary, effectively increasing your contribution by 50%. In short, employers that offer matching contributions to your 401(k) should be revered. This typically trumps any other consideration regarding the decision to contribute to a 401(k). It’s free money, like a year-end bonus that comes every 2 weeks – don’t turn it down.

With a 401(k), you’re forced into whatever management and investment options are offered to you by the plan your employer offers which usually mean the investment choices are restrictive and expensive. Things to watch out for in these investment plans are mutual fund expense ratios and investment options. A Roth IRA is extremely flexible and allows one to choose investment options – you even pick the custodian you want to use. Roth IRAs offer an advantage with regards to flexibility of investment choices, though if your 401(k) offers solid options, this may not be a great advantage;however, most 401(k) plans don’t offer solid options.

This is really the tough one out of the three because it involves a level of prediction of what the future holds for you. If you think your income tax rate will be higher at the time of withdrawal than it is currently, a Roth IRA is the better choice and will save you in the long run.

How can someone expect to know future tax rates? Here are a few things to consider:

401(k) or Roth IRA: So What Should I Do?

This is free money.

The question really revolves around what to do with additional retirement money. Given all the above factors, and also assuming you’re young and have many years of income growth ahead of you, a great option is a Roth IRA.

Finally, there are other tax-free retirement options to consider such as Roth IRA on Roids for slightly more sophisticated investors. It has all the benefits of a Roth IRA with no restrictions and guaranteed principal.

Whichever you decide to pursue, by simply putting money away, you’re ahead of the game. Don’t let the deliberation keep you from saving – if all else fails, start making contributions immediately to one or the other now and then finalize decisions later – you can always change your mind in the future.