Rothe IRA vs. 401k: Taxes & The Future

One big point that I often bring up in favor of Roth IRAs is the fact that you’ve already paid your income taxes on it. When you take money out of your Roth IRA at retirement age, you don’t have to pay income taxes on any of your withdrawals. On the other hand, with a 401(k), you’ll owe income tax on all of your withdrawals.

Obviously, the big difference comes when you pay into these accounts. With a Roth IRA, you put your money in after taxes – from your take-home pay. With a 401(k), you invest with money before taxes. Thus, a 401(k) investment reduces your taxes today, while a Roth IRA investment reduces your taxes tomorrow.

Many people want a simple answer to the question of which retirement account type is better – but it’s not that simple at all. To truly know which option is the best one would require a crystal ball.

The best we can do is make the case for a future where a Roth IRA is better – and a future where a 401(k) is better. Let’s look at each one.

A Roth IRA Is Better If…
income tax rates go up from where they’re at now. Let’s face it – the United States is deep into debt. The revenue to pay for that debt will have to come from somewhere. At the same time, income tax rates are currently about as low as they’ve been in decades. What’s a reasonable conclusion from this? The government will raise individual income tax rates gradually over time to make up for all of the rampant spending since the start of the Reagan years.

your earnings go way up from your current level. If you have higher earnings later in life, it’s likely that most of your retirement savings will also come later in life so that you can have a standard of living in retirement that’s notably higher than what you have now. If you need a lot of money in retirement, it’ll be very useful to have some of that money arrive on your plate tax-free, especially if the income tax rates are higher. In other words, if you have a big entrepreneurial bone in your body, a Roth IRA is probably a better option.

you have other avenues of income in retirement besides the Roth IRA. Most likely, if your income goes way up, you’re going to have investments of all kinds that earn income for you in retirement. Almost all of that will be taxable income. Again, having some of your income in a non-taxable form means substantially less taxes for you, particularly, again, if tax rates are higher.

your employer isn’t offering matching contributions into a 401(k). If you’re self-employed or with an employer that doesn’t offer a 401(k) – or doesn’t offer any sort of 401(k) contribution matching – a Roth IRA definitely looks good in comparison, since the 401(k) doesn’t have this huge advantage.

A 401(k) Is Better If…
income tax rates stay at the same level – or go down. Many argue that the best way to increase revenue is to actually lower tax rates, spurring on business growth. If future governments apply this philosophy, it’s likely that tax levels will either stay steady or decline.

your earnings decline, stay the same, or only go up at a slow rate until retirement. If you’re not entrepreneurial in any way, shape, or form and you’re not interested in battling your way up the corporate ladder, your income will likely remain pretty steady throughout your life. This means you won’t bump yourself up to higher tax brackets later on and you’ll likely be in this tax bracket (or a lower one) in retirement. Thus, deferring the taxes until then is advantageous.

your main income (besides Social Security) will be your 401(k). If your income in retirement will mostly come from your 401(k) and not from outside investments, your total tax bill will be limited significantly. You won’t have additional income pushing up your tax burden (which your 401(k) will contribute to).

your employer offers matching 401(k) contributions. This is free money that blows away any tax benefits that might come from a Roth IRA. If your employer matches your contributions, the decision becomes pretty easy – take those matches all the way to the bank.

What About a Roth 401(k)?
Some people also have the option of a Roth 401(k), which essentially works like a 401(k) except with after-tax money. A Roth 401(k) often ends up being like a Roth IRA that gets employer matching, which means that most of the arguments in favor of a Roth IRA apply to it.

In the end, though, you need to decide for yourself where you’re headed and where you believe the government is headed. Of course, all of this is moot if you don’t start saving right now. Regardless of what you choose, you’ll lose any advantage of either choice by putting off saving while you decide. If you’re unsure, sign up for one plan or another and start contributing. If you change your mind later, switch your savings plan. But, no matter what, start saving now – don’t put it off.

If you enjoyed reading this, sign up for free updates!

Loading Disqus Comments ...
Loading Facebook Comments ...
  1. jdb says:

    I’ve never understood the thinking that one would make more money in retirement than when working. What am I missing here?

  2. Mike Piper says:

    I agree that tax considerations are the #1 factor in the decision (after maxing out your match, of course).

    But it’s also important to remember that a 401(k) likely includes administrative fees that would not be charged via an IRA (at most brokerage firms, anyway).

    That extra .72% each year can really add up!

  3. Trent says:

    “I’ve never understood the thinking that one would make more money in retirement than when working. What am I missing here?”

    Imagine if you spent your life running a business, then you sold that business one day. You’re likely swimming in money.

    Another example: you spent your adult life socking away 20%-25% every single year.

    My best friend saves – in cash – about 35% of his take-home in addition to his retirement. He’s in incredible shape.

  4. Johanna says:

    Because of the way tax brackets work, it’s almost never a good idea to use *only* Roth investments to save for retirement, even if tax rates really do go way up. Deposits into your retirement accounts are taxed (or not) at your marginal rate, whereas withdrawals are taxed (or not) at your overall rate, which is lower.

    Being in the 25% tax bracket doesn’t mean that you pay taxes in the amount of 25% of your income. Instead, a certain amount of your income is taxed at 0% (i.e., deductions and exemptions), some is taxed at 10%, some at 15%, and the rest at 25% – so your total tax bill is less than 25% of your salary. (I know you’ve posted about this before, but apparently it’s something that people commonly misunderstand.)

    Now, say you’re in the 25% tax bracket, you’ve got $5000 to save for retirement, and you’re trying to decide whether to put it into a traditional IRA/401(k) (and take the tax deduction now but pay taxes later) versus a Roth (and pay taxes now but get tax-free withdrawals later). Suppose that employer matches are not an issue. If you choose the traditional, you’ll pay $1250 less in federal income taxes than if you choose the Roth – that is, it’s the 25% rate, your marginal rate, that’s relevant.

    Now fast-forward to retirement. Taxes will still work the same way, most likely, even if the specific rates are different: You’ll still be allowed some income tax-free, some taxed at the lowest rate, some at the next-lowest, and so on. Personally, I think it’s highly unlikely that the government will raise the lowest tax rates above 25%. So unless you have a *lot* of other income (for example, if you’re still working a full-time job), some amount of the money you withdraw from your traditional accounts will be tax free, and some will be taxed at rates less than 25%.

    That, I think, is a good reason to put at least some money into traditional retirement accounts, even if you have the option to go straight Roth.

  5. Tyler says:

    Seems like the best option for most people with access to an employer sponsored 401k is probably a hybrid. The contribution limits for a 401k are substantially higher than a Roth IRA. I believe the average person would have an awfully hard time funding any decent retirement from just social security and a Roth IRA.

    I currently contribute 15% (+3% employer match)to my 401k and only about 2% to a Roth IRA. As I look at how I will earn money in the future, I will probably start to slowly rebalance these contributions until I no longer have access to a 401k.

    Anyone have any knowledge about the tax implications of rolling over an old 401k to a Roth IRA?

  6. Michael says:

    There is another risk: Congress may amend the Roth IRA law to tax withdrawals after all! This would be totally unfair, but it’s definitely possible.

  7. Rick says:

    That is a big risk, but another bigger risk in my opinion is that Congress decides to go to a national sales tax. Now, I hardly think that if Congress does enact a sales tax, they will fully eliminate the income tax, but I’m sure it will at least be a lot lower. And if this happens, it will have been a bad idea to invest in a ROTH.

    That’s what I hate the most about investing, you never know how the government will interfere with the markets next.

  8. Greg says:

    I can’t imagine the government not raising the tax rates through the roof. For decades there has been no fiscal responsibility by our lawmakers. How on earth are we ever going to get out from under the national debt if they don’t raise taxes? On top of that, since we don’t manufacture much of anything anymore, when they can no longer delay payment by refinancing or printing more money there will probably not be enough income to tax. Rates will be going up or entitlements (and even the government) will be going down.

    My money is going into my Roth accounts on the hopes that they don’t get too desperate and renege on that tax promise too.

  9. veer says:

    Trent,
    I wished you had touched upon the power of compounding vis-a-vis Roth Vs 401K.

    Ramit touched it in his book “I will teach you to be rich” but I don’t know where I stand on that.

    401K will hold more money than a Roth. Which would mean that 401K after the same tax rate will fetch more money in the end.

    Did you think any on this angle?

  10. sidd finch says:

    why choose? offset the risk that either will be the “worse” investment and use both!

  11. J says:

    “no matter what, start saving now – don’t put it off.”

    This should be the first statement in the article, not the last, as it is by far the most important point of all. “Analysis paralysis” is most definitely real, and offering people three choices and then getting into speculation about taxes just makes is more confusing. I know that this is Important Stuff To Know And Understand, but most people quite literally see a ginormous wall of text and a lot of speculation about where the government is going with tax rates, and then more comments discussing minutae, and they go “oh bother, this stuff is too confusing, I’ll learn more later”.

    If you aren’t already contributing to a 401k, march right down to your HR department and sign up, even if you only do 1%. Get something going. Once you have some money in the game, you’ll care a lot more and be motivated to learn. You can always change things later.

  12. The points raised in the comments in regard to government needs for tax revenue and the possibility of higher tax rates are right on the money. There’s too much money sitting in or flowing into retirement plans for politicians to ignore in a mad dash to raise revenues.

    It would do us all good to remember as well that both 401k’s and Roths are political creations, and he who makes the rules can change the rules. Unfortunately, when you’re trying to prepare for a retirement that’s 20, 30, 40 years out, there is an element of fortune telling involved.

    I’d sugggest that you take both a 401k and a Roth, if you can, but more important, put more money into non retirement savings.

    Savings are savings, and retirement plans are just one vehicle class to accomplish your goals. They have tax benefits of course, but that can’t be the only objective.

    The one advantage you have with non-retirement savings is that they’re unqualified. There are no strings attached, no “gotcha later” provisions that you have with tax sheltered plans. So spread your money out, planning to rely on ALL of your assets in retirement, not just those labeled ‘retirement’.

  13. David says:

    FYI, Reagan deficits totaled $800B after 8 years. In the past 7 *months* the U.S. national deficit has grown by nearly $8T! 10X the spending in 1/10 the amount of time! Talk about rampant spending.

  14. Johanna says:

    “but more important, put more money into non retirement savings.”

    I don’t see how this can possibly be advantageous. In making the choice between traditional versus Roth, you’re choosing between paying taxes later versus paying taxes now. But by choosing non-retirement accounts over either of these, you’re paying taxes now (ordinary income taxes) AND later (capital gains taxes) AND in between (on dividends and interest).

    It is true that there is a risk that Congress could change the rules and increase taxes on retirement accounts (at least, as far as I know – I’m not a lawyer, so there might also, as far as I know, be some legal reason why such a rule change could be challenged in court). But is that risk worth resigning yourself to the guarantee of paying more in taxes through non-retirement accounts?

  15. Scotty says:

    I can’t help but to think taxes will increase in the future. I mean, c’mon, at some point in time all of this spending is going to come home to roost. A trillion dollars divided by America’s population (approx. 300M) works out to about $3,300 per person. And the national debt is up to what now, $11.5 Trillion? (http://www.brillig.com/debt_clock/). At 2% interest, that’s $115B per year just in interest payments! I think I heard on the news that every man, woman, and child in the US owes the equivalent of $6000 per person to China.

    I can’t help but to think this will all eventually come home to roost, somehow. I’m assuming ‘zero’ government aid for when I retire. Anything over and above $0/mo is gravy.

    I’d be interested to hear Trent’s take on the national debt situation. You can ignore it today, but just like Trent’s own situation, there comes a point where the bills are going to come in the mail and you wonder how you can make even the ‘minimum’ payments.

  16. George says:

    If you plan on retiring before age 59-1/2, then you MUST have money in non-retirement accounts that can be used to bridge the time until you can make withdrawls from conventional retirement accounts.

    If you’re old enough that you are counting on some Social Security, then a Roth will give you some tax-free breathing room before touching IRAs and 401(k)s.

    After age 70 (or is it only age 65?), you’ll find that a huge chunk of income is not taxed due to extra deductions and SSI exemptions.

  17. Johanna–To answer you’re well thought out objections–YES. I’m not saying forego tax sheltered plans for non-retirement, I’m saying have both.

    No one investment vehicle addresses all risks. It isn’t all about taxes. If you have most of your money in tax sheltered plans (and a lot of people do!), and you lose your job for a year or more–enough to drain your emergency fund–you’ll get clobbered on taxes by liquidating retirement plans (less so with Roths). In the real world this happens a lot to people who have most of their money in retirement plans.

    Having worked in financial services most of my life, I’ve seen this scenario over and over. If it’s prudent to diversify between investments, it’s equally prudent to diversify between savings vehicles. We just don’t know what life has in store for us.

  18. lucas says:

    just stumbled (and thumbed) this article – as a young canadian moving to the u.s. in the near future, this is valuable information to have rattling in my big flip-top head. thanks!

  19. Johanna says:

    “If you plan on retiring before age 59-1/2, then you MUST have money in non-retirement accounts that can be used to bridge the time until you can make withdrawls from conventional retirement accounts.”

    I disagree. First of all, you are never entirely barred from withdrawing money from retirement accounts – it’s just that certain early withdrawals are subject to a 10% penalty. Which is something you want to avoid, obviously, but it’s not the end of the world.

    Second, there are ways to get around that penalty. For example, you can withdraw your original contributions (as opposed to the money earned on them) from a Roth IRA penalty free. There’s also an exception where you can avoid the penalty if you take “substantially equal” monthly payments – which is probably what you would be doing if you retired early, anyway.

    Third, even in the absence of those exceptions, if it’s still early in your career, it still makes the most sense mathematically to put all your retirement contributions into retirement accounts, and wait until later to put any retirement savings in taxable accounts. This is because you want to give the money in the retirement accounts as much time as possible to compound tax free.

  20. Des says:

    Maybe I missed it, but it seems like you’re forgetting one of the major benefits of the ROTH. Your GAINS are tax free as well. If you contribute $50k and the value of your investments is $100k when you retire, you only paid taxes on the $50K, whereas you would pay taxes on the full $100k if it were a traditional account.

    So, its not just “pay it now or pay it later”. Its also “pay taxes on the contributions AND the gains, or only on the contributions.”

  21. Michael says:

    Greg, raising taxes to pay the national debt is not fiscally responsible. There is not enough money to pay the debt, and raising taxes enough to reduce it would kill the golden goose (we the people.)

  22. Jacob says:

    This article was poorly researched. First of all employers can’t match a Roth 401k with Roth dollars, their contributions are always going to be with Pre-tax dollars. Second of all there is no mention about the estate planning implications of Pre-tax accounts vs. an after tax (Roth) account. I normally enjoy reading your articles but I think that you could have researched a little better on this one.

  23. alex says:

    My favorite plan is maxing out the traditional IRA, retiring very early, then transferring the funds slowly into a Roth when you’re at a 0% tax rate. Never pay taxes on it.

  24. todo es bien says:

    Further complicating issues, my understanding is that you can access the principle of a Roth EARLY without tax consequences. (The earnings are the last to come out, and they would have tax consequences.) This point seems somewhat controversial I might add, but if that is the case the Roth offers more liquidity in a catastrophe than does the IRA. My 2 cents: if you have any kind of matching, do that one first absolutely to the point of maximizing the match. Then Roth. If you are able to do any more maximize the IRA.

  25. Johanna says:

    @Des: That’s not actually a benefit, because the amount of money you end up with is the same either way. It’s the percentage you pay in taxes that’s important, not the dollar amount.

    Let’s use your example of a $50k contribution that you expect will double between now and retirement. With a Roth, you pay taxes now, which reduces your contribution to $37,500, which grows to $75k, which you can then withdraw tax free. With the traditional account, you contribute the whole $50k, it grows to $100k, you pay $25k in taxes (you actually pay less than this, because of what I said earlier about tax brackets, which is a separate issue from what you’re talking about here) and keep $75k. Same thing.

    Now, if your reason for wanting to pay less in taxes is because you want to stick it to the government and give them as little money as possible, then that’s possibly an advantage for the Roth – although there’s the time value of money to take into account. Also, a far more straightforward way to pay less in taxes is to earn less money. But if your reason for wanting to pay less in taxes is because you want to keep as much money as possible for yourself, then it makes no difference whether you pay 25% now or 25% later.

  26. Johanna says:

    “No one investment vehicle addresses all risks. It isn’t all about taxes. If you have most of your money in tax sheltered plans (and a lot of people do!), and you lose your job for a year or more–enough to drain your emergency fund–you’ll get clobbered on taxes by liquidating retirement plans (less so with Roths). In the real world this happens a lot to people who have most of their money in retirement plans.”

    By my math, it still looks like the retirement account – particluarly the Roth – comes out ahead.

    With the Roth, you get your original contributions tax-free, and pay a 10% penalty on earnings. With the taxable account, you pay no tax on your original contributions, but pay a 15% tax (in most cases) on capital gains.

    Plus, with the Roth, your original contributions come out first, whereas with the taxable account, you must take them out together, so you get hit with taxes from the start.

    Plus, with the taxable account, you must pay income tax every year on stock dividends and bond interest at your full marginal tax rate, so your money will not grow as fast as it will in a Roth, where those things are tax free.

    Plus, with the taxable account, there’s a tax consequence if you want to rebalance your portfolio, whereas with a Roth, there’s not.

    What am I missing?

  27. Juli says:

    This blog entry is scary in the fact that it misses COMPLETELY that the Bush tax cuts EXPIRE in 2010. So of course tax rates are going to go up.

    Can you skip the psuedo-political analysis by criticizing the Reagan years? Taxes low = tax revenue high – it’s an empirical truth. Look at the great state of MI to see how increasing taxes decreases prosperity.

    One of JFK’s key economic plans included massive, across-the-board tax cuts, similar to those of Reagan. Much like the 1920′s and 1980′s, it was these tax cuts that led to the Golden Kennedy-Johnson years.

  28. NYC reader says:

    There are other reasons to prefer a 401(k) over a Roth or traditional IRA, even if you don’t get employer matching.

    I don’t recall the exact dollar amounts, but there is a difference in the amount of money which can be shielded from creditors for the different types of accounts. If I’m not mistaken, a creditor can’t touch a 401(k) at all, but there is a dollar limit on IRAs of all types above which a creditor can seize your assets.

    Don’t think that only irresponsible people declare bankruptcy or have massive legal claims against them. A court judgement in excess of one’s umbrella liability policy can do this, as can a catastrophic medical situation that overwhelms one’s health insurance limits.

    Another reason to favor a tax-advantaged account such as a 401(k) is that your Modified Adjusted Gross Income (a specific IRS term) will be reduced by the gross amount of your 401(k) contributions. This reduction in MAGI will increase financial aid eligibility for you and your kids. More grants, fewer loans. Also, retirement accounts of any type are not considered as assets when financial aid is calculated. Another reason to max out 401(k)s and IRAs before ever putting a penny in a 529 plan.

    Remember, your kids can get grants and loans for college, you can’t get grants and loans for retirement!

  29. Jim says:

    I agree with Johanna’s point that its good to have a combination of 401k and Roth to maximize the tax situation. Most people are going to retire with social security and a bit of retirement savings. So their income will not be high and their tax bracket will be low. Most people are best with pre-tax retirement savings for the most part because of this.

    Everyone seems to think its a given that taxes are going to go up in future decades because we have a large debt. That seems like common sense. But ask yourself when has that ever happened? When have our politicians sat down and all agreed that they should be responsible and raise our taxes because the national debt is too high? It hasn’t happened in my lifetime. It didn’t happen in the 40′s and 50′s when our debt was > GDP like it is now. I don’t think our politicians are going to spontaneously become financially responsible long term thinkers. If you look back 60 years the tax rate on median income households has not changed much even though the national debt has been up and down significantly. If you plot the national debt and tax rates over the past 100 years theres really no correlation between the two. Don’t assume taxes will go up simply cause our debt has.

  30. Tyler says:

    A couple other advantages of the Roth:
    -There is no age at which mandatory minimum withdrawals must be made, unlike 401(k)
    -Any money left in the Roth at death is passed on to your heirs tax-free as well
    -finally, unlike most 401(k)s, the individual is allowed to choose the broker or firm and with that comes more choices for investment vehicles (often decreasing fees). This is a largely overlooked advantage.

  31. KC says:

    concerning comment #1 – My father retired from the state at 60 – he draws a pension from that. Now he works part-time as an interpreter for the deaf making $40/hour. My mother worked as an OT for many years. She retires and collects from her 401k while also working part-time doing PRN work making $35/hour plus travel expenses. They both have Roth IRAs and social security they can tap if needed, too. So they are making more money in retirement than they did when fully employed. Imagine if they had invested in some dividend bearing stocks outside of their 401k and Roths as many their age have done? They’d have that dividend income as well. My parents do have quite a lot of cash in the bank – that’s a tidy little interest each month.

  32. TC says:

    It’s not just an either-or question. Depending on your age, you can only contribute $5K/yr to a Roth. Plugging that into a retirement planning calculator and see if you can afford to retire just on the growth of that. Even starting in my 20s, there’s no way that’ll be enough.

  33. It’s not unusual for people over 60 to be making the most money in their lives. A generation ago there were a lot of retired factory workers, now there are a lot of entrepreneurial types who are at the top of their game and refuse to stop working. Can you blame them?

    The idea that you’ll make less in your 60s or 70s no longer holds accross the board. Pension + social security + investments + part or full time work, it’s not so hard to imagine anymore.

  34. Amy says:

    Another important factor to consider – state taxes. If you plan to move from a low income tax state to a high income tax state at or before retirement, or vice versa, this is a huge consideration.

    For instance, if you live in California (high income tax) but plan to retire to Nevada (no income tax) a 401k may be a much better choice for you. If, however, you currently live in Wyoming, but desperately want to move to New York, investing as much as possible in the Roth until you move is probably the better choice.

  35. gerry says:

    My opinion is that if you have to pay more taxes, than you are probably making more money….I say invest in anything you can, both tax sheltered and non-retirement. If you have to pay dividend taxes and capital gains taxes, and your net is higher than what you previously contributed than you’re ahead of the game. If people would spend more energy helping and fixing themselves and less energy trying to predict what the clowns in washington are going to do, than our mess of a country would slowly work its way around.

  36. david says:

    @Rick (#6), it seems very likely that Congress will be passing a VAT (similar to a national sales tax) to supplement the income tax.

  37. getagrip says:

    As another point is the amount of money you want to put into retirement is more limited in the Roth versus a company plan as I recall, something like $16,500 401K versus $6000 Roth. So I feel there are a lot of folks, even if they max the Roth, looking at the 401K for additional means of retirement savings. I figure many folks will end up with a combination of both before they retire.

  38. Nancy says:

    I do not trust the government. I like the Roth better and I know the government has said that anything in there will be tax free but the government also said social security numbers would never be used for identification numbers and look where we are with that. One possibility is to do a 50/50 split or some combination similar to that. Or do Roth with the IRA and traditional 401(k). If the government needs to increase its tax basis those Roths will be a very tempting place to go as the baby boomers retire. Look at how they are moving to tax health benefits. Just take a look at history.

  39. Gerry (29) and Nancy (31)–Totally agree! Ultimately we’re responsible for us, and the only way to handle that is to be as prepared as possible and not put all of our eggs in one basket.

    Diversifying account types the way you would a stock portfolio will likely prove to be the best long term bet.

  40. thefamilynomics says:

    I think the taxes are going higher. That is why I think saving more and saving in tax friendly investments like ROTH IRA is key to how much we have for our retirement.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>