One of the most common retirement questions I get asked is: Roth IRA or 401(k)?
Although both are good options worth considering, the answer isn’t always as straightforward as one might think. Also, it’s crucial for you to understand that you may not even need to pick one or the other. If you’re able to contribute to a work-sponsored 401(k), there is no reason you can’t also contribute to a Roth IRA, provided you meet certain conditions.
Before we delve deeper into this debate, let’s first make sure we have a working understanding of each of these options for retirement and what they entail.
What Is a 401(k)?
A 401(k) is an employer-sponsored deferred contribution retirement plan, so named because it’s defined under section 401(k) of the IRS code. In a nutshell, it works like this: You sign up for a 401(k) plan in your workplace and choose investment options within the plan. Your workplace takes money out of your paycheck before income taxes are taken out and deposits this in your plan. In some workplaces, your contributions are matched by the employer.
Then, when you reach retirement age, you can take money out of the 401(k), but those withdrawals are subject to income tax – since you didn’t pay it earlier, you have to pay it later on. (The benefit of the deferred tax structure is based on the assumption that you’ll be in a lower tax bracket in retirement compared to your prime earning years.)
Currently, there is no upper income limit on who can contribute to a 401(k), but an individual can contribute at most $18,000 to his or her 401(k) in 2016, and the maximum total amount that can be contributed between employer and employee is $52,000 in the same year.
Benefits of a 401(k)
- Your contributions may result in tax savings during each year you contribute.
- Your employer may offer an employer match — a.k.a. free money.
- In most cases, the money you contribute can be taken directly out of your paycheck. Out of sight, out of mind.
- You can contribute a lot more each calendar year using this option (up to $18,000 per year in 2016)
You can find a lot more detail on IRS.gov.
What Is a Roth IRA?
A Roth IRA is an independent individual retirement account that you set up directly with an investment firm. Its name comes from its chief legislative sponsor, Senator William Roth.
With a Roth IRA, you can set up an account with any of the online brokers, choose investment options with them, and then directly deposit after-tax money (from your checking account, for example) into the Roth IRA. Then, when you meet a few basic requirements (once you’re 59 1/2 years old or older, and have had the plan for five years or more), you can withdraw both your deposits and investment gains completely tax free. You can also withdraw funds penalty-free to pay for a child’s education or a down payment on your first house.
In 2016, the maximum contribution you can make to a Roth IRA is $5,500 a year (unless you’re over 50). However, there is one big caveat: There are income limits on who can contribute. If you make more than $116,000 individually or $183,000 jointly, you can’t contribute the full amount (and may not be able to contribute at all). You can find out a lot more detail in the Wikipedia entry on Roth IRAs.
Roth IRA Benefits
- Your eventual withdrawals will be tax-free since you funded your account with after-tax dollars.
- You can actually withdraw your contributions at any time without penalty. (You cannot begin withdrawing your earnings before age 59 without incurring a penalty)
- Unlike with a work-sponsored 401(k), your Roth IRA will allow you to pick and choose a brokerage firm and your individual investment options.
Roth IRA vs 401(k): What Are the Major Differences?
The big differences between the two are employer contributions, investment options/management, and taxes. Let’s look at each aspect.
With a 401(k) retirement plan, an employer may match contributions made by an employee up to a certain percentage. For example, let’s say you contribute 10% of your gross salary to your work-sponsored 401(k). In some cases, your employer will match your contributions up to a certain percentage, usually somewhere between 3-6%.
When your employer offers a perk like this, it is crucial that you take advantage of it. It’s free money, after all – don’t turn it down. In a nutshell, employer contributions are also one of the advantages of using a 401(k) in the first place. Since a Roth IRA is funded only with your after tax dollars, you won’t receive this benefit when you use that particular type of account.
Although receiving an employer match when you use your 401(k) can be rather attractive, that doesn’t mean that using that particular type of retirement account doesn’t come with its own set of drawbacks. With a 401(k), you’re tied into whatever management and investment options are made available to you by the plan your company offers. In some cases, that means that your choices could be rather sparse and not all that great, although that isn’t always the case.
Important items to look out for in your investment plans are expense ratios and investment options. The best employer plans will have low expenses and as many options as possible.
With a Roth IRA, you are allowed to choose your management and thus also your investment options – you pick the investing house you want to use. Roth IRAs offer an advantage in that they allow you to choose your plan’s manager, though if your 401(k) offers good options, this may not be a big advantage.
Advantage: Roth IRA
Another big difference between a 401(k) and a Roth IRA is the way taxes are paid on both your contributions and your withdrawals. In short, your 401(k) plan is funded with pre-tax dollars, which can be beneficial since it reduces your tax liability during each year you contribute — often in the prime of your career. However, the money you eventually take out of your 401(k) will be taxed upon withdrawal at your current tax rate.
Meanwhile, a Roth IRA works in almost the exact opposite way. The money you contribute has already been taxed, which means that making a Roth contribution won’t affect your taxable income in the year you contribute. However, since you have already been taxed on your contributions, you won’t need to pay taxes when you begin withdrawing funds for retirement.
Advantage: It depends on your tax rates
How can you know which rate will be higher? Here are a few things to ask yourself.
Will my income increase between now and retirement? If the answer is yes, you’ll likely be in a higher tax bracket when you retire, which favors the Roth. If you’re near your peak, you’ll probably be in the same bracket or lower, which favors the 401(k).
Will I be working in my retirement years? If the answer is yes, you have a much higher chance of at least being in the same tax bracket you are now.
Will the political landscape shift towards higher tax rates? This one, honestly, is complete guesswork. If I had to guess, I would speculate that tax rates will go up in the future. If that’s the case, you might want to lean towards a Roth IRA since your future distributions will be tax-free. If you expect to pay a lower tax rate in the future, however, a 401(k) funded with pre-tax money might be a better bet since you won’t be taxed on that money until you retire and begin taking distributions.
Best Strategies for Maximizing your 401(k) or Roth Contributions
Contributing to at least one type of retirement account faithfully is crucial if you ever hope to retire. In most cases, Social Security funds will not be enough to sustain you, and your cash savings probably won’t have the opportunity to grow the way they would if you had invested that money all along.
When it comes to picking between a Roth IRA and 401(k), there really is no perfect answer. Your individual situation will impact which plan works best for you, and even then, there are several different ways to look at it.
It’s also important to note that you don’t have to pick one type of account over the other. You can contribute up to $18,000 to your 401(k) and put up to $5,500 in a Roth IRA or traditional IRA that same year. Here are a few different strategies you might want to consider as you move forward.
Max out your 401(k) and contribute to a Roth. If your work-sponsored 401(k) offers low fees, plenty of options, and an employer match on your contributions, you might want to max out for your 401(K) and contribute to a Roth IRA. This is a great strategy for anyone who has extra money to invest and wants to lower their tax liability.
Contribute to your 401(k) up to the company match, then begin funding your Roth IRA. If your work-sponsored 401(k) doesn’t come with the best options but you still want to take advantage of your company match, you could always contribute a percentage equal to what your employer has pledged to contribute, then focus on contributing to your Roth IRA. Young people especially should consider the future benefits of a Roth IRA since many experts agree that tax rates could go up significantly over the next few decades.
Contribute a set amount to each type of account each month. If you are struggling to decide which type of account will benefit you in the long run, you might just want to split the difference and contribute equal dollars to both. Set up your 401(k) contributions to include a percentage of your income that you can easily match in your Roth IRA. Then make a commitment to invest every month, no matter what.
Best Roth IRA Providers
Using a 401(k) means taking advantage of the investment options and brokerage firm your employer has chosen for you. However, with a Roth IRA, you are on your own to make this important decision. Fortunately, several online firms offer a vast array of financial services that include Roth IRA set-up and management. Here are a few of the best online options as well as a basic rundown of what each has to offer.
There’s a reason over six million people hold accounts with TD Ameritrade. Founded in 1971, the company has proven itself over the years by offering excellent customer service, investment professionals you can count on, and fees that are competitive with similar firms. Although TD Ameritrade charges a slightly higher fee for trades at $9.99, they offer other features that some say more than make up for it, including the opportunity to speak with a financial advisor for free during one no-obligation consultation.
Beyond the basics, here are a few of the biggest benefits that come with choosing TD Ameritrade:
- Excellent support and customer service: TD Ameritrade customer support is available 24/7.
- One of the best trading platforms in the business: Unlike other brokerage firms with somewhat basic trading platforms, TD Ameritrade is known for its superior trading platform and powerful research tools.
- No minimums: With TD Ameritrade, there is no minimum opening deposit.
- Local branches for convenience and service: Much like Scottrade, TD Ameritrade also offers convenient local branches for more personalized service.
As one of the first brokerage firms to go online, E*TRADE is one of the most established and trusted of the bunch. All E*TRADE customers have access to streaming stock quotes, various financial and investment tools, and below-average account minimums. Investors who make between 150 and 1,500 trades per quarter also qualify for a low $7.99 commission rate, while investors who make more trades often qualify for even lower rates. Meanwhile, E*TRADE also offers many commission-free ETFs, as well as mobile access, 24/7 customer service, and some physical branches. Beyond those basics, here are some of the major benefits that come with choosing E*TRADE:
Plenty of investment options: With E*TRADE, you’ll have access to over 8,000 mutual funds, 1,300 of which come with no load and no transactions fees. In addition, you’ll also have access to forex/future trading, which isn’t always available with other online firms.
Low account minimums: To open an account with E*TRADE, the account minimum is only $500 or $2,000 for a margin-enabled account.
Excellent trading tools: Beyond their basic trading platform, E*TRADE also goes out of the way to ensure maximum trader education with powerful trading and research tools that are available to all users.
When it comes to online brokerage firms, Scottrade is known for offering low priced trades and quality customer service. However, low fees come at the cost of less than stellar investment tools and features.
Some other benefits of Scottrade:
- Streaming quotes: Unlike many other online brokerage accounts, Scottrade doesn’t make you pay extra to see streaming quotes from day one. You simply need to open an account and fill out a few forms to gain access.
- Scottrade Elite: Fund your account with more than $25,000 and you qualify for Scottrade Elite, a VIP service that opens up options for advanced tools and charting.
- Low fees and no hidden charges: Beyond the $7 flat unlimited trade fee, you can also use Scottrade without worrying about hidden fees or charges.
- Plenty of investment options: With Scottrade, you can choose to invest in everything from stocks to mutual funds and banking products. Their mutual fund offerings alone give you more than 14,000 options to choose from.
The Robo-Advisor Roth IRA Options to Consider
While many people enjoy trading stocks and learning more about investing, others would rather minimize their fees, and use a buy-and-hold strategy.
Fortunately, there are several online investment firms that can help you manage your retirement and put you on a path toward meeting your long-term goals without ever setting foot in an office or feeling pressured to invest in high cost funds. Here are a few of the best online financial planning firms out there:
Betterment is similar to other online brokerage firms in that it provides you with a place to manage your retirement and investment accounts. However, Betterment has taken the stance that too many fees can eat into your long-term returns and adjusted their fee schedule accordingly.
To cut down on fees, Betterment uses low-cost exchange-traded funds, or ETFs, that are similar to mutual funds but able to be traded like stocks. In addition, Betterment offers a ton of comprehensive wealth management features that many of the stock trading firms do not, such as automated portfolio rebalancing, tax-loss harvesting, and automatic dividend reinvestment.
Betterment’s fees are also highly competitive when compared to traditional managed accounts. Currently, their fees are based on your portfolio balance, and come in three tiers:
- Builder: 0.35% of your average annual balance of under $10,000
- Better: 0.25% of your average annual balance over $10,000
- Best: 0.15% of your average annual balance over $100,000
Each of these options comes with no transaction fees, no trade fees, and no rebalancing fees. However, free tax-loss harvesting is only available for the Better and Best plans. Meanwhile, individuals whose investments fall in the Builder tier (accounts under $10,000) must set up $100 per month in auto-deposits and pay a $3 per month account management fee.
Much like Betterment, Wealthfront offers low-cost, liquid ETFs (exchange-traded funds) in order to cut down on the overall cost of investing for its customers. Wealthfront does not allow for individual stock trading at all, however, and instead focuses on using ETFs to help you create a customizable investment and retirement plan. If your goal is to automatically invest a certain sum of money each month and have your investment automatically picked for you based on predetermined criteria, then Wealthfront could be for you.
In addition to the use of low-cost ETFs, Wealthfront also offers several benefits that can help you learn more about investing while optimizing your returns. Some of those benefits include automated portfolio rebalancing, automated tax-loss harvesting, and the Wealthfront invite program, which can help you earn free services in exchange for referring family and friends. Here’s how the fees stack up:
- Your first $10,000 invested with Wealthfront is managed for free.
- Everything you invest beyond $10,000 is charged a 0.25% management fee annually.
However, it is important to remember that you could realistically get your services for free just by signing up and getting several people to do the same with your referral code. For each person you get to sign up, you currently get an additional $5,000 managed for free. Depending on how much you have invested, and how many friends and family members you have, you could earn the right to have most of your investments managed for no out-of-pocket expense at all.
With Personal Capital, you have two options to choose from: You can either sign up for their free service in order to gain access to a number of wealth management tools for no out-of-pocket expense, or you can sign up for their paid service which includes access to a personal financial advisor.
The free service that Personal Capital offers is rather remarkable. Once you link your accounts, you will gain not only a clear picture of your net worth, but access to innovative tools such as a 401(k) fee analyzer, investment checkup tool, and a tool that shows you your ideal asset allocation target. Personal Capital also tracks your spending for you and puts things in perspective with easy-to-understand graphics and pie charts.
When it comes to the paid service, Personal Capital is one of the only options that assigns you a personal financial advisor. However, that privilege does come at a price. The following list shows just how much you’ll pay Personal Capital to oversee your entire investment portfolio:
- Accounts up to $1 million: 0.89%
- Accounts up to $3 million: 0.79%
- The next $2 million: 0.69%
- The next $5 million: 0.59%
- Over $10 million: 0.49%
Although these fees are higher than some of their competition, they are still significantly lower than the fees charged by traditional financial advisors for managed accounts. To cut down on the overall fees associated with managing your account, Personal Capital uses baskets of individual securities and ETFs to create a model portfolio. Keep in mind that wealth management, trade fees, and custody are all included, so their pricing is truly all-inclusive.
Even if you don’t choose to use Personal Capital to manage your Roth IRA and other investments, you still have a lot to gain by signing up for their free wealth management tools. Sign up and you can easily find out your net worth, how much you’re paying in retirement fees each year, and your ideal asset allocation. Signing up is free and you have nothing to lose.
Choosing the Right Option
Whether you’re choosing between a 401(k) or Roth IRA, or simply trying to choose which brokerage firm you want to use to make trades or manage your investments, it’s important to remember that there is never a one-size-fits-all option. To figure out what is best for you, you have to explore all of the pros and cons with each opportunity and figure out how they relate to your own situation.
The most important thing to remember is that, in most cases, time is on your side. The earlier you start investing and saving for retirement, the better off you’ll be. So take time to choose which type of retirement options is best for you, but don’t let having too many options deter you from making a decision altogether.