Many new investors wonder if they should invest in the 401k or Roth IRA. Both of these are tax-advantaged retirement accounts, but there are differences. Ideally, you should contribute the maximum to both your 401k and Roth IRA. That’s what we do. However, it’s a lot of money when you’re starting out. Some people can’t contribute that much. Which one should you invest in if you can’t contribute the maximum to both accounts? First, we’ll quickly go over the 401k and Roth IRA. Then we’ll see which one we should invest in first.
The 401k is a retirement savings plan that’s usually sponsored by your employer. An eligible employee can make pre-tax contributions through payroll deductions. (Some plans have the option to contribute with after-tax income.) Here are the advantages of the 401k plan.
- You’ll pay less tax today. Your contributions won’t be taxed and it will grow tax-free. You will pay taxes when you withdraw it later.
- The contributions will be taken out of your paychecks. It won’t pass through your checking account so you won’t be tempted to use it. This is the easiest way to invest.
- Many employers offer matching program up to a certain percentage of your salary. So if your employer matches 5% of your salary, then your contributions will instantly double (up to 5% of your salary.)
- The 2019 maximum contribution is $19,000.
The Roth IRA is another retirement savings account. However, you have to manage it yourself. When I first started working, I opened a Roth IRA with Firstrade because their fees were very low. They’re even better now. The online trading fee is $0 even for mutual funds! Here are some advantages of the Roth IRA.
- You invest with after-tax money. The great thing is you will never have to pay any tax on the gains.
- You can withdraw your contributions anytime with no tax or penalty.
- You can invest in anything you like. Usually, the 401k has limited options.
- In 2019, the maximum contribution is $6,000.
Read more – How to start contributing to a Roth IRA.
The beauty of these two retirement accounts is that you can use them in tandem to avoid the 10% early withdrawal penalty. They will come in very useful if you plan to retire early. You can read more about this process – Build a Roth IRA ladder to minimize taxes in early retirement.
Should I invest in the 401k or Roth IRA?
Ideally, you should contribute the maximum to both the 401k and Roth IRA. However, most new investors don’t have that much income. To max out both accounts, you’d need to save $25,000. That’s a lot of money. If you can’t save that much, then do this.
First, contribute to the 401k up to the employer matching. This is the best investment you can make because your investment will double right away. If you’re not contributing this much, you’re giving up free money. Let’s calculate and see where to invest after that. I’ll use an excel spreadsheet to do this.
Here are some assumptions.
- The investor is in the 22% tax bracket. He can invest $6,000 in Roth IRA or $7,690 pretax in 401k.
- 8% annual gain.
- The investor starts at 22, retires at 60, and lives until 86.
- The withdrawal rate is 7% at 60. I made the money run out at 86.
- After retirement, the investor will have a lower effective tax rate due to not having a job. I assume the investor will pay 12% tax. This is a big assumption, but it should be valid. Most retirees make less money after they retire and pay less tax.
Here is the graph of the 401(k) vs Roth IRA.
As we expected, the 401(k) portfolio grows much more than the Roth IRA. That’s because you don’t have to pay tax initially and can invest more. The 401k grows to $1,829,768 by the time we’re 60 years old. The Roth IRA grows to $1,427,647. That’s a big difference.
We need to zoom into the withdrawal period to see the differences between the two. This graph shows the income after tax.
We can see the 401k comes out ahead.
- 401k: total $4,214,958 before portfolio depletion (after 12% tax)
- Roth IRA: total $3,737,107 before portfolio depletion (after 0% tax)
That’s almost half a million dollars more if you invest in the 401k.
Why does the 401k come out so far ahead? The big difference is due to the decrease in the tax bracket. The 401k has an advantage because we assume the tax rate will be lower after retirement. I assume if you pay tax now, you’ll pay 22%. After retirement, you’ll pay 12%. That’s the secret sauce.
However, if your tax rate will be higher after retirement, then the Roth IRA will win. Some people think the tax rate will increase in the future, but I disagree. Low-income workers already struggle mightily to make ends meet. Increasing tax at the lower brackets will make life a lot more difficult for them. I think the higher tax brackets will see more change.
What if you’re in the same tax bracket after retirement
*This section is a follow up to a comment.
The 401k is clearly better if you’re in the lower tax bracket after retirement, but what if you’re in the same tax bracket? The 401k will still come out ahead due to subtlety in the tax code.
Let’s do an example of a childless family making $150,000 per year.
When they contribute to the 401k, they save 22% in taxes right away.
After this family retires, they still generate $150,000 from withdrawal. They will be in the same tax bracket as before retirement. However, their effective tax rate is 13%. Their effective tax rate is lower than their marginal tax rate. The $150,000 income is taxed at different rates as you move up the brackets.
- 10% for $0 – $19,400
- 12% for $19,400 – $78,950
- 22% for $78,950 – $168,400
There is a spread of 9% in the tax rate even if they make the same amount of money after retirement. The 401k still come out ahead. That’s the difference between effective tax rate and marginal tax rate. If this is confusing, you should read up on the difference between the two.
- Effective tax rate = total tax / taxable income.
- Marginal tax rate = the percentage taken from your next dollar of taxable income.
For us, we should be in a lower tax bracket after retirement. Our effective tax rate will be around 7%. That’s a huge spread of 15%. I seriously doubt the tax code will change that much, but who knows.
In conclusion, it’s better to max out your 401k first then work on the Roth IRA. Most of us will be in the lower tax bracket after retirement. Assuming your 401k plan is good, it’s best to go with the 401k first. Of course, it’s best to max out both your 401k and Roth IRA as soon as you can. That’s the best of both worlds.
*The only reason to not go with the 401k first is this. If your 401k is really bad and the employer doesn’t match. In that case, you can open a traditional IRA and skip the 401k.
Okay, what do you think? I love my 401k because auto deduction makes investing so easy. It’s the best way to invest, especially for beginners. The Roth IRA is really good too. That’s why I invest in both of them.
*Sign up for a free account at Personal Capital to help manage your net worth and investment accounts. I log in almost every day to check on my investment. It’s a great site for DIY investors.
Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!
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