Monday, April 30, 2007

Roth IRAs vs. 401(k)s

CNN Money recently had an article discussing Roth IRAs vs. 401(k)s. The columnist, Walter Updegrave, correctly emphasizes at the beginning of his advice that, for a person in their 20's, deciding to save anything at all is a major victory. To think I was 31 years old and, besides the house we had just put 20% down on, we had $28,000 to our name. I should have been able to save up more throughout my 20's, but just didn't do it. And I did not have to pay for my own schooling. So shame on me - at least I'm making up for lost time now.

The first point to be made is that you should max out any match you get on your 401(k) at work. When comparing a Roth IRA and a 401(k), no amount of tax analysis you do can trump getting free money today from your employer. If you are lucky enough to have a match, it's the easiest advice I can give - take this free money!

The rest of the decision, according to the article, has to do with taxes. A 401(k) is a better deal if you think your tax rate will be lower in retirement, and a Roth IRA is a better deal if you think your tax rate will be higher. The article goes into alot of detail that I will not rehash. It does correctly point out that, unless you're Kreskin, you may have a very hard time guessing what your tax bracket is going to be in 25 or 30 years. Going a step further, can we even know what our tax system will be like in 30 years? Will we go to a flat tax, as much of Eastern Europe has adopted? The top marginal income tax rate in the 1970's was 70%. Now it is half that. Could the long-haired Led-Zeppelin-listening muscle-car-driving investors of the 1970's have predicted that the top rate in the new millenium would be 35%? No way. Honestly, this uncertainty has me caring less and less about this decision of where to save - do some 401(k), do some Roth IRA = JUST DO SOMETHING!

One thing the article does not mention, but that you should consider, is what I call "investing freedom." I love my IRA's, because I'm able to freely trade (read: buy) stocks in them. I cannot do this in my retirement plan at work (which is a SIMPLE IRA - we don't offer a 401(k)). I get a dollar for dollar 3% match here at work, so I pump money into the plan here first. Then I fund Roth IRA's. Then, if I have any money left over to save, I pay off our Home Equity Line of Credit. But I really like those IRA's that I have because I'm able to buy the small cap stocks that I want, and that investing freedom has really paid off for me in the last year.

3 comments:

KMull said...

401k match = 100% return. Immediately.

One could argue for the Roth's because you could say "I paid my taxes. I never have to worry about taxes again."

Thoughts?

Q said...

Yes, the match is powerful stuff. I know some folks live paycheck to paycheck and find it hard to max out their 401(k) to the point where they get the full match. But you have to find some way to do it! Your financial future depends on it.

Roths are better for the very reason you state. My wife and I each have a Roth, and now we each have a traditional IRA. We opened the traditional IRAs to accept rollovers from 401(k)s.

As you said, with a Roth, you pay your taxes, and you're done. Then you invest the money, hopefully see it grow by 10x, and then that huge pile of money is available to you tax-free. Tax free growth and tax free withdrawals - I think that is superior to shielding yourself from tax now, but paying tax on a hugely appreciated pile of money.

The MediaBlog said...

I'm strictly using my 401k right now. I keep thinking that I should be putting money into a Roth but so far I've talked myself out of it.

My 401k is a sure thing in the sense that I've already escaped paying taxes on the money I put into it. A Roth, on the other hand, is based on the government's promise that they won't tax me later.

My fear is that in 20 or 30 years when people start retiring with a million dollars sitting tax free in their Roth accounts, politicians will suddenly start screaming about "the rich" not paying their fair share. All those people who are saving nothing now will buy it hook, line and sinker.