Choosing a Roth IRA or 401k for investment purposes

Looking at anything in a vacuum can be dangerous, so we all must assess the various offerings that our own retirement accounts, whether they be 401k, IRA, or Roth IRA provide us. Obviously there are other offerings such as 403b, 457, 409A, SIMPLE IRA, SEP IRA, etc.
Since this information and the associated guidelines change possibly every year due to pay increase/decrease, IRS guidelines for retirement accounts, income taxes, etc., this analysis is best to perform every year to determine which approach is best for your own specific case.
In this article, we’ll ask ourselves whether we should be choosing a Roth IRA or 401k for investment purposes.

This analysis is more from the perspective of if you cannot afford to put away that much money and you are willing to actively manage your own retirement account.

Very knowledgeable folks such as Financial Samurai have provided one point of view as to why you should choose a 401k or tax deductible IRA (aka Traditional IRA) instead of a Roth IRA. I would like to point out 2 different points of view.
I will assume a withdrawal rate of 4%/yr because that is considered a “safe” withdrawal rate by most financial advisers.

First off, I would strongly suggest that you fund your 401k to the maximum amount that your employer matches. If that is 3%, put 3% into your 401k to double your earnings without lifting a finger. If it is 4%, put 4% into it. After that you very well may want to try and fund a Roth instead of a Traditional IRA.

For some information up front, you are allowed to put away a huge amount more into a 401K in comparison to at least 3x as much into a 401K! Starting in 2013, the 401K limit is $17,500 that each person is allowed put into their 401k, but the IRA limit is only $5,500. If you are over 50 years old, the limit increases the amount someone is allowed to put away by an additional $5,500 or $23,000 for the 401K (401K IRS link). If you are over 50 years old, you is allowed to put an additional $1,000/yr into the IRA, or $6,500/year maximum (IRA IRS link).
Keep in mind that the limits shown above are for an individual. If the person is married, then the numbers double, although in the case of a Traditional 401K, the spouse has to work for an employer that allows that type of plan for their retirement package.

      401k vs Roth IRA – A lot of 401K’s allow for only mutual/bond funds, and not ability to purchase individual stocks. Can you earn more in individual stocks than you can in mutual funds … yes. Obviously the contrary is also true, you could buy an “Enron” type stock that ends up dropping precipitously and perhaps to even $0 worth and taking everyone along with it while the mutual funds may not go down as much as any one specific stock. What about fees charged for putting your money away? Over at My Journey to Millions, Evan shows that even if he wants to choose to keep his contributions in just cash to try and time the market a little better, he gets charged almost 1%/year for them simply to keep his cash in the 401K, and they pay less than that in annual earnings! :-(
      I am fortunate that all of the funds that are available in my 401K have pretty low fees & expenses of 2% or less, but most of them are actually under 0.50% (yes 1/2%). Now that is rather low, but it certainly isn’t as low as individual stocks purchased in nice round blocks of 100 (or even 50), and having an expense of a mere $10 or less. One of the investment firms I use is actually only $7.95 for an unlimited number of shares bought/sold, although there also is a 1¢ to 3¢ additional charge for every $1,000 sold – which is evidently an administrative SEC fee, so for the sale of $10,000 worth of a security, it may cost an additional 10¢ to 30¢.
      Now, unless I misunderstand the fee schedules, let’s say the fund managers charge a 1%/year fee for keeping your cash with them. If your portfolio is $100,000, that will cost you $1,000/year. Now, if they are making you 15%/year, that’s well worth it since that will have your 401K will grow by about $14,000 for the year after expenses. Well worth it obviously, since you got to keep almost 93% of the increase in your account … and perhaps simply withdraw that amount over the course of the year.

      Traditional vs Roth IRA – This is a little simpler than the above analysis, simply because most IRAs allow for an individual to trade stocks, bonds, and mutual funds, which is very much like a Roth IRA. Let’s say you would buy/sell the same stocks over the same time and analyze the results. Let’s use someone that would be in the 25% income bracket. We’ll talk about percentages, merely because they change year to year, depending upon your income and whether you are filing married/single/etc.

      $5,500 for 2013 are currently the limits for IRAs, but we will assume that you put your money into only one or the other.

      Now say you put this away for 20 years and earn 10%/yr. That will allow either IRA to be at $387,000 in 20 years. And if you just let it sit there for an additional 3 years without putting anymore money into the account it will be worth more than $500,000 if it still earns at that same rate.
      If you take away 4%/yr from each of those values, you get the amounts: $15,480 (@ $387,000) and $20,000 (@ $500,000). Obviously you can double this for a married couple, and you’d have taxable amounts if it is through a pre-tax IRA, however you wouldn’t have to pay any tax if the withdrawals were from a Roth IRA.

      If you bump the rate you can earn up to 16%, that same account would have a value of $860,000 in 20 years, and if you let it sit there for another 3 years without putting anymore money into the account it will be worth more than $1,300,000 if it still earns at the same rate.
      Where can you earn a rate like this? Well, some dividend paying stocks such as AGNC pay 15%-16% if you purchase the stock at a low enough cost per share. As a matter of full disclosure, when I began writing this article, I owned shares of AGNC and have traded it at other times in the past.

In our particular case (married with kids and a single income and about 11 years away from the ripe age of 59 ½), I believe that we may benefit from putting money into a Roth IRA as opposed to a 401K, although I will definitely meet the company match. As we have planned, we’ll max out the 401K to company match first, then fund the Roth IRAs for each of us, and then if there is more, bump up the 401K contributions.
And while you are limited if you are single to putting away 68 ½% less into an IRA than you can into an IRA, if you are married, it is limited to 37% less that you can put into an IRA than you can put into a 401K.

I’ll put the full mathematical analysis and additional reasoning in an upcoming post.

Choosing a Roth IRA or 401k for investment purposes Part 2

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4 Responses to Choosing a Roth IRA or 401k for investment purposes

  1. Pingback: Choosing a Roth IRA or 401k for investment purposes Part 2 | Rich In The Heart

  2. Good topic I’m very passionate about. Bottom line, most people will earn less in retirement than while they work. Makes sense right? Therefore, to pay taxes up front while they work is silly.


    btw, consider installing a social plugin so I can share over Twitter!

    • Quite true Sam that they will earn less in retirement than while they work.
      However, that discounts compounding doesn’t it? After all, if you manage to sock away $30,000 within the first 6 years of working and let it build over say 37-40 years, you’ll get to $1M.
      So now you start withdrawing from that after age 59 ½ @ a simple 4%/yr. That’s $25,000/yr that would NOT be taxed at all if it were in a Roth IRA, but would if it were in a Traditional IRA or 401K. Granted I don’t know how it would affect Social Security payments one might receive although I’m sure that would lower any SS payments.
      I believe that there’s a point where one’s effective tax rate is low enough, it will produce a much better tax situation when one starts to draw on the retirement account. Especially if you are in the lower tax brackets to begin with (i.e. when you are even younger than 20 years old).

      The only way you not pay taxes, is to earn obscenely low amounts of income, or guarantee that your income isn’t taxed some time in the future, like you can do with a Roth IRA/401K, or even using capital gains tax rates.

      Will look into the social plugin although I honestly don’t have a Twitter account. Seems like it’s about time to do that. Not to mention open up some advertising on the site. :-)

    • Oh, one other benefit in our case that I forgot to mention is that we can make use of the spousal IRA. So if you can afford to do it, you can put away $11,000/year ($5,500/yr for each spouse), into their own IRA account. That’s only 37% less than a 401K that you can contribute into a Roth, which is considerably better than the 68% lower amount if you are single.
      That gets a lot closer to the $17,500 limit of a 401K.
      Obviously the limits increase once you’re past age 50 for both the IRA and 401K for “catch up” contributions.

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