Roth IRA vs 401K

Roth IRA vs 401k: Are you faced with the dilemma of deciding how to direct your retirement contributions? Certainly, your first retirement dollars go to your 401k if you're getting a match. After that, especially if you're young and have plenty of time to rack up tax free earnings, you may want to consider filling up your Roth IRA. A Roth IRA can do things that your company’s 401(k) can’t. Even if your company offers a Roth contribution option, you still should be making yearly contributions to a Roth IRA.

401(k) – The Cornerstone of Your Retirement Plan

Don’t get me wrong. Your 401(k) should be the principal vehicle you use to save for retirement, especially if your employer offers a match. If you’re not contributing at least enough to get your company’s maximum match, that money your employer was trying to give you as part of your compensation package is lost forever.

Also, the 401k limits on yearly contributions are much higher when compared to Roth IRA contribution limits. Still, when it comes to a Roth IRA vs 401k, investing in both is your best choice.

Roth IRA vs 401k Loans

Everything doesn’t always go as planned. If things go awry and you need cash, raiding your 401(k) is an expensive way to get it.

Depending on your company’s plan, usually it’s no problem qualifying for a hardship withdrawal, but you have to pay tax plus the 10% early withdrawal penalty (assuming you’re under age 59 ½) in most cases.

Most likely your company allows you to loan money from your 401(k). The money you loan out to yourself – regardless of whether you made traditional or Roth contributions – eventually gets taxed twice.

Both of these options are expensive. That's why when it comes to a Roth IRA vs 401k, it's best to make yearly contributions to both.

A Roth IRA is More Liquid

You can tap your previous Roth IRA principal contributions at any time, for any reason, with no tax or penalty. It’s been my experience that a lot of folks don’t know this. Roth IRA earnings are another story and should be left alone until you’re at least age 59 ½.

Here’s a simple example. Let’s say Kevin has been making $2,000 yearly contributions to his Roth IRA for the last four years, and his current Roth IRA balance is $10,000. Kevin could withdraw $8,000 to pay a big medical bill, supplement his expenses while between jobs, take a European vacation, or any other reason you can think of.

I’m certainly not advocating withdrawing the principal – better to leave it in there and generate more tax-free earnings – but it’s a much cheaper source of cash than tapping your 401(k).

And emergencies do happen…

Roth IRA and 401k Make a Great Team

All 401(k)s offer traditional contributions, where your contribution is tax deductible and earnings accrue on a tax-deferred basis. More companies are now offering a Roth 401k contribution as well, where the contribution is not tax deductible but earnings grow on a tax-free basis.

Still puzzled as to where to direct your retirement contributions (Roth IRA vs 401k)? It still makes sense to contribute to a Roth IRA even if you are offered both contribution options at work because of the liquidity issue. Plus, it expands the amount you can invest per year for retirement.

Don’t think you make too much money to invest in both a Roth IRA and 401(k); those magi limitations can be avoided. See the 'Ole Roth IRA Switcheroo for more details.

Diversify the Way You Save

A Roth option diversifies the way you save for retirement, whether you do so through your company or on your own via a Roth IRA.

Remember, your traditional contributions (and associated earnings) are like a ticking time bomb – you’re not really sure how much will be available for retirement. That money is 100% taxable and subject to future ordinary income tax rates, and whatever they’ll be is anyone’s guess.

Qualified Roth IRA distributions are free of federal, state, and local taxes forever, giving you a hedge against future higher tax rates. And unlike 401ks, a Roth IRA is not subject to required minimum distributions.

Invest in Both a Roth IRA and 401k

Roth IRA vs 401k? Investing in both is the best option. Not only will you have the ability to save more on a yearly basis, a Roth IRA is the more economical vehicle to raid in case of emergency.