4 Reasons Why a Roth IRA May be Better Than Your 401(k)

by Darwins Money on 31 March 2011 21 comments
Photo: jygallery

Retirement planning is wrought with "rules of thumb," asset allocation recommendations, compound return assumptions, pension and/or Social Security income calculations, inflationary expectations, and more. Getting to "that perfect number" is an effort in futility unless you can see into the future with perfect clarity. So, aside from planning conservatively and starting early, a key consideration within your control now is the determination on where you direct your retirement dollars early in your career for the best net benefit in retirement. (See also: The End of the 4% Rule?)

The conventional wisdom on retirement savings has traditionally been that you should always invest in your 401(k) plan at least up to the limit of the company match. After all, who would argue against a free 100% return or whatever the match amounts to? But what about when you surpass that amount, which might only be the first 4-5% of income investments, if at all?

If your company matches funds up to say, 5% of your salary, but you could reasonably afford to invest another 10% of your income for retirement, would your money be better off topping off the same 401K(k) account or would you be better of investing the same funds in a Roth IRA account (noting the Roth IRA limit of $5,000 per person annually)? (See also: How to Make the Most of Your 401K)

Here are 4 reasons why those additional funds may well be better off in the Roth IRA.

Fees Matter!

With investors focused so much on stock market returns and volatility, the unsung hero of long-term investing is low fees. Even in the most aggressive conventional asset class, equities might reasonably be expected to return 9% per year including dividends. When you consider that inflation could reasonably average 3% or more over the ensuring decades, that's a net 6% return in real dollars. Now, factor in a difference of 1% in a high fee versus low fee mutual fund and the difference in compound returns really adds up!

It's now becoming common knowledge that company-sponsored 401(k) plans often offer sub-par mutual funds that are both high-fee and generally don't even match their benchmarks. Contrast that with the ability to select a low-fee ETF or mutual fund in a self-directed IRA account and right off the bat, you're looking at improved returns over a prolonged period of time. Personally, I have funds in my company plan with expense ratios in excess of 1% while Vanguard offers many mutual funds closer to 0.10%. Over the 30 years I have until retirement, that 1% difference can add up to six figures or more!

More Options

Aside from being presented with higher fee options, 401(k) plans often offer only a single choice in a given asset class. Your plan might have all actively managed mutual funds based on say, Large Cap US, Small Cap US, European Growth and a Bond Fund. What about if you want to diversify further into Emerging Markets, commodities or even various high yield investments which can flourish in a tax advantaged plan since income accrues untaxed? You are strictly limited in your 401(k) plan while you have thousands of investment options in a Roth IRA ranging from mutual funds to ETFs to stocks to bonds (see the risks/benefits of ETFs over other investments). You can even own gold in an IRA, not that I'm an advocate.

A friend of mine sells mutual funds for his firm to corporate clients for their 401(k) plans. He said what he hears over and over is basically a conservative mantra: "We're not looking to be superstars here. We need to avoid being sued. We aren't going to offer our employees exotic or volatile funds." Companies aren't in the business of providing you a lot of options. They're trying to just keep up with the competition and offer a "decent" total benefits package which often includes a modest match and some funds to choose from. But probably not the range of funds you'd invest in if you had the choice — like you do in a Roth IRA you set up yourself.

ARTICLE CONTINUES BELOW

Tax Rates Are Likely to Rise

The tradeoff with a 401(k) versus a Roth IRA is that with the 401(k), while the amount you invest is deducted from your taxable income in the current year, you have to pay taxes on the withdrawn amount in the future. Conversely, with a Roth IRA, you invest now with after-tax funds, but regardless of tax rates in the future, those earnings can be withdrawn tax-free. So, it often comes down to an assumption about tax rates.

The "conventional wisdom" had always held that you're probably in a higher tax rate today than you will be in retirement because you won't be working the same full-time job and might only be collecting Social Security and some retirement income. However, this whole notion of tax rates needs to be reconsidered.

See, it is a mathematical certainty that the US can't continue to meet its debt obligations without increasing taxes, especially on the upper-middle class and higher. Unless your income is very low on the spectrum (in which case, the ability to invest excess funds to this degree may be limited), there's a decent chance that in the coming years, tax rates will begin to increase. After all, we're in the midst of a temporary, controversial, negotiated "Bush-era" tax rate regime right now. But the political will and fiscal ability to make the current tax rates permanent just isn't there.

Additionally, while my income may decrease in retirement, so will my deductions. I will no longer have a mortgage interest deduction and I won't be getting state tax deductions for 529 Plan Investments. Therefore, if you assume that your effective tax rate in retirement may be higher, or even just roughly equivalent to your present tax rate, then the "conventional wisdom" no longer pushes the equation in favor of 401K(k) investing and the other considerations above should take precedent.

Flexibility for Emergencies

Not that you want drawdown of your principal as a retirement planning philosophy, but in the event of extreme need, one can withdraw the principal portion of IRA contributions without penalty, whereas in a 401(k), there's a 10% penalty incurred plus the taxes of course, since they were deferred initially. There are some provisions of hardship associated with 401(k) plans, but the restrictions are rather onerous whereas the Roth IRA is flexible. This shouldn't be an up-front expectation that you'll be withdrawing funds prior to retirement, but it might be comforting to know that there's added flexibility in that portion of your retirement assets, as opposed to having everything in the 401(K) which would be subject to penalties and taxes.

The reality is, nobody knows what's going to happen 20 or 30 years from now. But the priorities of diversification, minimizing expenses, and optimizing your tax liabilities may well push you more in the direction of Roth IRA contributions over 401(k) contributions once you exceed a company match.

Note that 403(b) and other equivalent plans have similar attributes to the 401(k) and can be used interchangeably throughout.

Where do you invest extra retirement funds?

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Guest's picture

Thank you for addressing a frequently asked question. People with 401ks constantly run into this allocation decision and don't know what to do. You have laid it out perfectly. The higher fees alone could be reason enough to choose a Roth IRA over 401k contributions (after company match). Increased fees over many years are one of the great killers of performance and hurt investors returns far more than most realize.
Thanks for the great article.
Ken Faulkenberry

Darwins Money's picture

Thanks Ken, glad to hear you agree! I just wrote my check to top off last year!

Guest's picture
Guest

If I already had filed my tax return, can I still do it for the 2010 tax year? I mean would I have to file an amended tax return, and if so would I also get additional tax refund?

Darwins Money's picture

You can't deduct Roth IRA contributions, so any time up til Apr 15, you can make prior year contributions with no regard for tax return filing status.

Guest's picture
Guest

In "extreme need" you shouldn't withdraw from Roths or 401(k)s--you should file bankruptcy. Your debts will be discharged and your Roth and 401(k)s are exempt from your creditors.

The only "extreme need" justifying raiding your ERISA-qualified accounts would be to ransom a family member....and then only if you REALLY liked that person ;)

Darwins Money's picture

Filing for bankruptcy has much more dire consequences than simply borrowing and replacing funds in many cases. I borrowed from my 401(k) once in my early years. It worked out fine. I paid the interest back to myself and the market hadn't moved at all during the payback period.

It's a personal decision. As long as people understand the consequences of either option, they should be able to make a sound decision.

Guest's picture
Guest

but you can only put a max of 5000 in roth when you could put as much as 23000 in 401b

Darwins Money's picture

Correct; covered that in the article. It's the incremental $5K you might normally just "automatically" plop into the 401(k) or equivalent, when it might be better off in a Roth IRA.

Guest's picture
Guest

Great article. What you might make clearer, though, is that you can (and maybe should) contribute to both a Roth and your 401(k) up to the max allowable. If you can afford it, you don't necessarily have to choose, and both offer tax advantages over straight/non-retirement investing.

Guest's picture
matt

Great article. I definitely agree that after you meet your employers Match you should put all additional funds towards your Roth IRA. My problem is finding the extra funds to contribute to my roth. :)

Guest's picture
Justin

Ever since learning about the ROTH IRA, I've been putting money into mine.

Granted it isn't that big yet (only been working full time for 2 years), but it's definitely growing.

Anyways, think you had a few great points. Because taxes will most likely increase, a ROTH makes sense. Plus, as you get older you will most likely be making more money than you do now, right? That means a higher tax bracket.

I do put some money into my 401K equivalent, but it isn't matched so there's not a huge incentive to put it all in there.

Guest's picture

This is a very though one to figure out, and part of it is based on speculation. Yes tax rates are going to rise, but it also depends on how close you are to retirement age, and what your tax bracket will be at the point you begin withdrawing! Not to mention all those years you could receive compounding interest on tax-free money, granted you will be taxed at some point, but while its in the account it gives you a higher prinicpal on which to earn interest...over the years this really adds up. Also, for those who contribute to a 401k just years shy of retirement, if you open up an IRA you wont be able to touch the funds for at least 5 years, and Im willing to bet this is an issue for some older folks.

Guest's picture
Andrew

Justin, the point about compounding interest on the additional (because not paid in tax) principal in the 401(k) is one I have been stumped about for a long time. Does anyone understand the math well enough to explain it here?

Here's the scenario: let's say I have $5000 that I can invest for retirement. I can:

(1) Put all $5000 into a 401(k), earn compounding interest on the full $5000 all the way until retirement. Then I get taxed (maybe more, maybe less) on money and the interest when I take distributions during retirement.

OR

(2) Pay (let's say) $1000 in taxes now and invest $4000 in an IRA. I now have less money compounding in the investment, but I don't need to pay any taxes on it when I take distributions.

It seems to me that even if I am paying a higher tax rate during retirement, I'm still better off having all that compounded interest even if I have to pay a percentage of it in taxes. (That is, the compound interest on $1000 MINUS taxes is still better than no compound interest on $1000.)

A lot of people who understand the math of investing better than I do seem to still think IRAs are a better way to go, so I wonder what I am missing. Can anyone explain this?? Thanks!!

Guest's picture

@Andrew,

I like you laying it in such a succint format. To be honest, nobody can say with 100% certainty which method is better...since tax rates will most likely (but who knows for sure) rise by the time I reach retirement age (im 30 now). But let me lay it out like this:

Say I choose to put $100 tax free dollars into my 401k (above my employers match) every month...at my 25% tax bracket that would be only $75 a month in my IRA. That is an extra $25 of principal I am earning interest on... my rate of return since inception of my 401k is about 12%. That comes out to be an extra $3 month I earn in interest. Next month I now make 12% on $53 (25 from previous month + 25 from current month + 3 in added interest)...so on and so forth.

Let me also add that I do add much more than just $100 over my employer matching contribution each month...this adds up quickly!

Tax rates MIGHT go up...how much and when, we will never know, its all speculation. But right now the math doesnt lie...with 100% certainty you will make MORE money with a 401k (provided the same rate of return) but you can only guess with an IRA depending on the gov't tax rules some years down the road. Telling you to invest an IRA over a 401k is equivalent to me telling you the next big stock pick of the century, we dont have crystal balls.

Thanks for your feedback, I like when people reply to comments!!

Guest's picture
Andrew

Thanks for the reply, Justin! (And sorry for the inordinately long reply below -- I hope it is helpful to someone other than me!)

Your explanation confirmed my understanding of the "conventional wisdom" that compounding interest makes a HUGE difference when you are investing over a long period. Since it makes such a huge difference, my thought was that surely the compound interest on the extra (pre-tax) money that you can invest in a 401(k) would be greater than the percentage increase in the tax rate. For instance, even if my tax rate goes up from 25% to 35%, I would have earned way more than 10% of my investment with that additional compound interest.

But your explanation pushed me to look into the math more closely. And now I am pretty well convinced that the additional compound interest doesn't make ANY difference in the end. This is counterintuitive given the way I laid out the scenarios above, but I think it ultimately makes sense.

So, the formula for compound interest (assuming it compounds annually) is:

Future Value = Present Value x (1 + r)^n

Let's take your two scenarios again but assume that the tax rate remains EXACTLY the same between now and retirement (just for the sake of comparison). So, let's say the tax rate (t) = 25%.

In both scenarios, let's assume the rate of return (r) = 12% and the number of years it has been compounding (n) = 30.

If I have $100 to invest, I could put all of it in a 401(k) and let the full amount compound for 30 years:

Future Value (30 years from now) = Present Value x (1 + r)^n =
$100 x (1 + 0.12)^30 = $2996

But of course, now I have to pay taxes on the future value when I take distributions. Rather than getting the full $2996, I get 75% of it. So, my "take home" from investing the full $100 in the 401(k) is $2296 x 0.75 = $2247.

Now, what would have happened if I invested in a Roth IRA? I have $100 to invest, but I pay 25% tax on it first. So I have $75 left to put into the IRA and only that $75 earns compounding interest over the next 30 years:

Future Value (30 years from now) = Present Value x (1 + r)^n =
$75 x (1 + 0.12)^30 = $2247

When I am retired, I can take out ALL of that $2247 without paying more taxes (assuming the laws haven't changed). So my "take home" with the IRA is *exactly* the same as it would have been had I invested the full $100 in a 401(k), $2247.

Now that I look closely at the math, this outcome makes sense. The compound interest formula is simply a series of multiples. The tax rate is only one more multiple added to the series. The only difference (in our simplified scenarios) is that the IRA multiplies by the tax rate FIRST, and the 401(k) multiples by the tax rate LAST. But, of course, order of operations doesn't make a difference in multiplication. So:

(PV)(t)[(1+r)^n] = (PV)[(1+r)^n](t)

This is really counterintuitive given my initial thought that compound interest makes a HUGE difference! How could it make NO difference?? I think what I was failing to recognize is this: even though my extra $25 is earning a huge return based on compounding interest, the EVEN HUGER return on the other $75 of my investment will also be reduced by 25% when I eventually pay my taxes. Compound interest does make a huge difference -- but 25% of a huge amount of money (the full return on my other $75) is still a pretty huge amount of money to pay in taxes. In fact, it is EXACTLY as much money as I earned by compounding the interest on the additional (pre-tax) $25.

In the end, the tax rules for the 401(k) and IRA don't have any impact at all on the potential for earning compound interest.

Of course, as you and the post writer have pointed out, there are other variables that we've ignored in our scenario. If my tax rate goes up, then my "take home" on the 401(k) will be smaller. But if the legislature changes the tax rules for IRAs at any point before I retire in a way that requires me to pay more taxes, then I could end up with the same (or worse) tax liability on an IRA. I am inclined to agree with you that this whole debate ends up being based on different gambles about what will happen with taxes.

Now that I see the real differences between the investments, my own personal strategy is this: above and beyond the employer match, diversify between a supplemental 401(k)--actually, I'm in a 403(b), but all the same--and a Roth IRA. Since it's easier to get money out of a Roth pre-retirement, there's some reason to have part of my savings in that kind of investment rather than a 401(k). And since the rest is a gamble, it's best to spread the odds out over both kinds of investments. How much of a split will depend on some of the questions in the post--which one has better options? Which has lower fees?

Anyway, that's my take. (If I've missed anything in the math or the explanation, I hope someone will correct me!)

Guest's picture

More options for a novice that doesn't know much about investing is actually a bad thing. They are better off picking a target date retirement fund or a mix of large cap, international equity, and bond funds.

Plan sponsors have a fiduciary responsibility to offer prudent investment selections. That is the primary reason you see few investment choices. That is also why fees should be low in most of the 401k options. Not saying that all plan sponsors are doing the right thing, but it's a shame to the uninformed participants if they aren't. I know for my company, the average expense ratio is 0.28%

At least there is going to be more visibility into fees with the new requirements from the Department of Labor.

Guest's picture
Debbie M

My 403(b) has no company matching (because they pay into a pension). So I max out a Roth IRA first because of lower-fee options and more choices. The rest goes in a Roth 403(b) (and toward pre-paying my mortgage).

I chose Roths because I'm guessing my taxes are going nowhere but up (I'm still in the 15% marginal tax rate). I stay in Roths because my pension is taxable, so my other money will be nontaxable--this will keep my future marginal tax rate lower. I also like the ability to pull principal from my Roth IRAs as a way to design my own early retirement. You can pull out all your money any time so long as you use an approved formula over an approved minimum length of time, but I like that I can pull out the amount I contributed without having to make sure it fits into an approved formula if I want to.

One more note: If you don't like your choices for your 401K, talk to your HR people and tell them what you like. Sometimes that actually helps. (We have Roth 403(b)'s available as well as regular 403(b)'s because people asked for them. HR thought they were a good idea but didn't feel like doing all the work involved unless they knew people wanted them.)

Guest's picture
MWF

The issue with Roth IRA's is what is preventing the government from changing the rules when it's time for me to retire, and suddenly my tax free retirement money is subject to a new tax anyway? And who plans on staying in the tax bracket they are in now once retired, I would rather pay taxes later, and bring myself into a lower bracket now, and be in a lower tax bracket when it's taxed in the future anyway.

Guest's picture
Mick

would you rather be taxed on the seed or the crop??????

Guest's picture
equalityjones

Since I recieve a match for the first 5% I put in, my pretax retirement always gets 5% of my income. And since I am the poorest I ever hope to be ( I qualify for the EITC) the rest ( what little i can muster) goes to my Roth. If for some reason poverty strikes me again in old age, I will not pay much in taxes on that first 5% -which already has a guaranteed 100% return due to the match and of course nothing owed on my Roth. Now If I because wealthy or upper middle class ( I hope my Master's degree was not for naught), my pretax retirement can afford the hit as my money has already doubled by default ( barring a crash of course) and again I would owe nothing on my Roth.
My plan is as follows:1. 5% of my income in pre tax vehicle with match.2 Roth contributions up until the $5000 a year maximum 3. then what ever more I can afford to contribute back into the pretax vehicle.

The MAIN variable truly, political elections.
Interestingly enough , a flat tax would garner no difference in whether the seed or harvest is taxed.

Guest's picture

Great article. For some reason, the benefits of Roth IRA's simply don't get enough traction with young people. If you are in a relatively low tax bracket (as most young people are), and especially if you are not getting a company 401K match (or you already contributed to get the full match), coupled with the flexibility of withdrawals in the future, the ROTH IRA is tough to beat.