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Why I’m Prioritizing a Roth IRA Over a 401(k)

by Darwin on March 27, 2012

Presented with the choice between maximizing contributions to either a 401(k) or a Roth IRA, many people opt for the 401(k). The prospect of “pre-tax” deductions from the paycheck is appealing since those contributions effectively reduce your tax bill each year. Additionally, the 401(k) deductions are totally on auto-drive. The money comes right out of your paycheck and goes directly to the investment firm. There’s no budgeting, there’s no check-writing or bank transfers. People find it to be convenient and automatic. Contributing to a Roth IRA however takes a bit more effort. First, you have to set it up. Then, if you don’t have automatic deductions coming out of your bank account, you need to remember to make electronic contributions or write checks. Finally, many people aren’t convinced it beats a 401(K) anyway.

  • Company Match Can’t Be Beat – First off, I don’t care how great an investor you think you are in a self-directed IRA or how bad your fees are in your 401(k) plan. If your company offers a match up to some portion of your earnings, even if just a 50% match dollar for dollar on say, the first 6%, then put in 6% minimum! Never, ever forsake a company match. You’ll never earn 50%, 75% or even the 100% that many companies offer up to a set amount in any other investment. However, after that, where is your money best directed?
  • Tax Rates Are The Key – People often assume that their tax rates are going to be higher now while they’re working than later in retirement. I beg to differ. The current financial situation in the US makes it a virtual mathematical certainty that tax rates for most Americans will be vastly higher in the future than they are now. We’re now living in the era of the artificially low “Bush Tax Cuts” that were subsequently extended by Obama to curry favor with middle-class voters. However, our deficits keep increasing our national debt by $1 Trillion or more per year and it only gets worse with a wave of retirees coming into the system. Tax rates will go up, even for the “under $200,000″ crowd. There’s talk now of increasing the capital gains rate and dividend tax rates as well. So, when I look at what my retirement income will look like in retirement, it will be a mix of social security and pension, both of which will be taxed at a higher rate than today mixed with investment income, also taxed at a higher rate.
  • Fees Matter – Even though there’s legislation due to take effect which will shine a light on company plan fees, that doesn’t guarantee that fees will ever match what you can get in say, a Vanguard IRA with expense ratios in the 0.1%-0.2%. There will still likely be higher administration fees, but now you’ll at least be able to see them. Over a few decades, the difference in fees really adds up, further favoring better returns in a Roth IRA.

If you don’t have your own IRA now and want to start a self-directed IRA where you can buy a basket of high-yield stocks or even use options for income, you should check out how you can get 100 free trades for starting up a self-directed IRA. The way I run mine, I have several stocks yielding about 7% as a mix. Regardless of what kind of stock price moves I see in the portfolio, as long as they maintain (and often increase) their dividends, I’m earning a 7% return tax-free which keeps getting rolled into new shares.

 

What Are Your Thoughts on 401(k) vs. Roth IRA Prioritization?

{ 19 comments… read them below or add one }

Sameer March 27, 2012 at 10:40 am

I think you might be making a mistake. Have you read this piece against the roth 401k? Similar arguments should apply to the roth IRA.
http://thefinancebuff.com/case-against-roth-401k.html

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Darwin March 27, 2012 at 9:53 pm

I disagree for the following reason – while tax rates are tiered and with a 401(k), yes you’re effectively getting the tax rate in that “higher bracket” but the same exact logic holds for future retirement distributions from a 401(k) being taxed at a high rate rather than a Roth IRA not being taxed at all in retirement. Why? Well, I already will have fixed income of Social Security, a pension, and probably some more W-2 or self-employment income even in retirement which will be taxed at those lower rates. So, it is apples to apples – a high tax rate deduction now with 401(k) vs an even higher tax rate in the same bracket in retirement that I can avoid with a Roth IRA.

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Long-Term Returns March 27, 2012 at 11:27 am

Tax rates will probably go up on average, but not so much that Roth is the right choice for everyone. If you are a high earner now — say, 35% bracket — and want to retire quickly and frugally — say, 15% bracket — then almost certainly you should be using traditional IRA and 401k instead of their Roth versions. The key is to make reasonable guesstimate of your personal tax brackets now and in retirement.

Also note that even if your tax bracket is low now, you could still lose out with Roth investments if US switches from income-oriented tax to consumption-oriented tax favored by Republicans. Not saying it’s likely, but it could certainly happen.

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Darwin March 27, 2012 at 9:55 pm

If you’re in the 35% tax bracket, you wouldn’t qualify for a traditional IRA deduction. Also, if switching to a consumption-oriented tax, both investment plans would suffer in the end – either non-tax Roth IRA withdrawals or taxable 401(k) withdrawals would still see a consumption tax when spent, right?

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Long-Term Returns March 28, 2012 at 1:20 pm

Good point about the 35% bracket — let’s pretend I wrote 25% and not 35% :) But if the switch to consumption tax is made in the future then Roth definitely becomes unattractive because its big benefit is future tax-free withdrawals. Traditional IRA/401k “start off” as more attractive by immediately lowering your taxable income. Roth is expected to “catch up” at withdrawal time with tax-free withdrawals. If all withdrawals for all tax-sheltered accounts become tax-free (since it’s consumption and not income that gets taxed under our assumption), then Roth loses to Traditional.

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JT March 27, 2012 at 12:36 pm

Personally, for people my age (early 20s), I don’t know how much value really exists with a Roth account. Certainly, I should expect that I will be in a much higher marginal bracket at retirement, and that tax rates might go up over time. However, I also think within the time from my contributions to the time I become eligible for distributions, consumption taxes will make up a greater portion of tax revenues from individuals. I don’t know how future politicians will reconcile the fact that a consumption tax is simply a way to tax already saved, post-tax cash such as that in a Roth IRA.

As unpredictable as the markets may be, politicians have to be even more unpredictable. For that reason, I’ve mostly shunned retirement accounts in favor of taxable accounts. Retiring at 59.5 years old isn’t necessarily a goal of mine – I’d prefer to have enough to retire far earlier than that – so right now, taxable accounts it is! It might break from conventional wisdom, but my position doesn’t fit the conventional mold. Young people who start saving early should be able to retire far earlier than 59.5 years old.

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Darwin March 27, 2012 at 9:57 pm

Taxable is good now if you’re in growth stocks and even with dividend stocks while tax rates remain low. Unfortunately, politicians seem to equate dividends with Romney with Warren Buffet’s secretary and all kinds of other nonsense with the end result being higher tax rates on dividends and capital gains. That’s where a Roth IRA would be nice – to be able to invest in individual stocks and ETFs without regard to tax rates.

On the consumption tax thought, wouldn’t all investments be subject to the same disadvantage though? Taxable, tax-advantaged alike?

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krantcents March 27, 2012 at 1:46 pm

Why not do both? It is more of a sacrifice, but worth it. Contribute enough for the 401K for the employer match and contribute to a Roth IRA.

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Darwin March 27, 2012 at 9:58 pm

Agree, that was my first bullet. Always, always hit the company match first, then switch over to IRA is my thinking (even though I’m not doing exactly that somewhat out of convenience – it’s my plan)…

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Roger the Amateur Financier March 27, 2012 at 5:31 pm

I’m with Krantcents on this one; trying to make decent contributions to both Roth and traditional style accounts is probably the best bet. While you raise a good point, noting that taxes are almost certainly going to have rise (and rise hard) in the coming years, when you have the (at least) three or four decades I do between now and retirement time, you have to think about EVERYTHING that could happen. From potentially increasing consumption taxes to a vastly restructured federal government to the possibility that by the time I’m able to retire, we may have gone through a whole cycle of higher taxes and another Reagan has brought it back down to current levels (or lower), there’s simply no way to know for certain how tax rates in 2041 (when I start withdrawing profits tax-free) will compare to current taxes, and thus, which is the better option for me. So, both it is!

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Darwin March 27, 2012 at 10:00 pm

To be honest, with how corrupt our system is, and how our constituency has no qualms about taking from others, it wouldn’t surprise me to find out that Roth IRAs end up being taxed on the way out in the end anyway. Who’s to stop some pandering politicians from saying that it’s primarily the well-to-do who actually plan for the future anyway, so they can afford to be taxed on their Roth withdrawals. Who knows?!

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Martin March 28, 2012 at 5:22 pm

Because the money was already taxed once…expect the earnings. So who knows? You may have a valid point.

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Roger the Amateur Financier March 29, 2012 at 11:10 pm

True enough; I actually pointed out that Roth accounts possibly being taxed is one reason it’s hard to say for certain whether Roth or traditional accounts are the better option. I do hope that if future politicians do end up taxing the Roth, though, they at least come up with a better justification than ‘it’s primarily the well-to-do who actually plan for the future’; it’d be a very depressing future if a majority of people agree that trying to save money indicates you must be rich.

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Darwin March 29, 2012 at 11:25 pm

Presently, the narrative is that if you have been successful and earn over an arbitrary amount, you are a “rich fatcat”, so who knows how the successful will be judged in the future?

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YFS March 27, 2012 at 7:32 pm

I’m a fan of the 401k to the employer match, max out roth IRA then back to maxing out 401k. IF you have the coin to do so.

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Darwin March 27, 2012 at 10:00 pm

Yup, that’s my plan too.

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Martin March 28, 2012 at 5:29 pm

Luckily for me, my 401k has the Roth option. So I could potentially hit the 401k, 17k contribution limit, then the IRA 5k limit. Company contribution is still pre-tax, but in retirement, you still have deductions to write off.

Is there some sort of a statistic or chart available that shows the growth of the Roth 401k option?

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101 Centavos March 28, 2012 at 11:11 pm

I expect that at some point the dividends in a Roth will go back to being taxed. I was more than a little torqued when the feds restricted HSA accounts. Give with one hand, take with the other.

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Karunesh @ chase-a-dream.com March 29, 2012 at 5:50 am

I agree with you, its better to pay taxes now. Paying taxes would hurt more in old age. Roth IRA is definitely better

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