The 401(k) vs. the Roth IRA. Which is Better?

 401k Roth IRA

401k Roth IRA

The Capulets vs. The Montagues.

David vs. Goliath.

The Union vs. The Confederacy.

The 401(k) vs. The Roth IRA?

Pitting retirement accounts against each other is not quite as thrilling a comparison as others, but the exercise is important as young families make plans for building future wealth.

Two of the most popular retirement accounts--401(k)s and Roth IRAs--are nearly identical in purpose but worlds apart in their composition.

In this post I’ve broken the main characteristics of 401(k)s and Roth IRAs into four categories. It’s impossible to make a true “apples to apples” comparison of these retirement accounts, but I hope this can get you a little bit closer and help your family make smarter decisions around your retirement.

(Note that all contribution limits, age limits, and taxes are based on 2017 figures.)

CONTRIBUTIONS

The 401(k)

Contribution limits for 401(k)s definitely have Roth IRAs beat. Limits for the 401(k) max out at $18,000 per employee, but that’s not even the whole picture. The employer can pitch in their share, too. Employers can contribute up to $35,000 per employee as well. That’s a total of $53,000. For many 401(k) holders, part of that employer contribution comes as a match if the employee contributes a certain amount.

401(k)s also don’t have an income cap as other retirement accounts do. It doesn’t matter if you make $30,000 a year or $30,000,000. All earners can participate, but none can contribute over $18,000 per year.

The Roth IRA

Contribution limits for Roth IRAs are much lower compared to 401(k)s. Maximum contributions are capped at $5,500 per year, and since Roth IRAs are not employer sponsored plans there are no employer contributions.

Roth IRAs also have an income cap. Married couples filing jointly can only participate if their combined income is below $194,000. Contributions also start to phase out once your income surpasses $184,000.

Winner: The 401(k)

TAXES

The 401(k)

Traditional 401(k) contributions are made with pre-tax dollars. This means you receive a tax deduction now and will pay taxes later when you retire. If for example your marginal tax rate is 25% and you make a $500 monthly contribution to your 401(k), you will receive a tax deduction of $125 (25% * $500).

All investment growth over time in your 401(k) is also deferred for tax purposes. No income taxes will be owed on your investment gains until you start taking withdrawals.

The Roth IRA

Roth IRA contributions are made with after-tax dollars. This means you receive no tax break now but you will pay no taxes when you retire. A $500 monthly contribution to a Roth IRA is just that--with no further tax deduction available.

Investment growth over time in your Roth IRA is also tax-free.

Side Note: There is some debate over which retirement tool is the right approach from a tax perspective. Retirees tend to have a lower income since they’re earning less (they’ve retired, so they have little or no wage earnings). This causes many investors to lean towards paying taxes later as with the 401(k), when they’re in lower tax brackets.
Unfortunately, no one has a crystal ball to see whether taxes will be higher or lower in the future. The potential of paying lower taxes should be weighed in the balance with paying your taxes now and being done with them forever.

Winner: A tie

INVESTMENT OPTIONS

The 401(k)

401(k)s are handled by a plan administrator in connection with your employer. Your plan administrator determines, with some input from your employer, which investments to provide in your 401(k) plan. You choose your investments from this list of options. Most 401(k)s have 20-30 different choices of mutual funds.

Most 401(k)s provide enough investment options to create a well-diversified portfolio comprised of such mutual fund classes as U.S. stock mutual funds, international mutual funds, bond mutual funds, and many others.

Roth IRA

One of the biggest advantages of most IRAs is the wide access of investment options. Are you interested in buying individual bonds of a specific company? Great. Do you prefer certain types of mutual funds not available in your 401(k)? There are thousands available in most Roth IRAs. Want to have a failed stock picking experience similar to my own? Go for it! All of these investment options and many more are available in Roth IRAs.

The one drawback of so many options is just that--too many choices. Inexperienced investors can quickly become overwhelmed at the wide variety of choices.

Winner: The Roth IRA

FEES

The 401(k)

401(k)s have a bad reputation for being riddled with fees. Unfortunately, the notoriety is warranted. Not only are there administrative fees charged by the plan administrator, but there’s are individual fee within each mutual fund as well called an expense ratio. These and other fees within 401(k)s are rarely noticed nor pointed out.

Fees, in particular the expense ratios, are the silent killers of many 401(k) plans as the chart below illustrates*. Over long periods of time, the fees can cost hundreds of thousands or even millions of dollars in fees.

  Assumptions: $10,000 tax deferred annual investment in monthly increments; 8% nominal returns while working; Fees could be as low as 0.1% and as high as 3%; and Investing starts at age 22 and retirement at age 62. Source: http://www.physicianonfire.com/investment-fees-will-cost-millions/

Assumptions: $10,000 tax deferred annual investment in monthly increments; 8% nominal returns while working; Fees could be as low as 0.1% and as high as 3%; and Investing starts at age 22 and retirement at age 62.
Source: http://www.physicianonfire.com/investment-fees-will-cost-millions/

A recent 401(k) I reviewed for a client illustrates the point well. I personally consider any mutual fund with an expense ratio above 0.50% to be expensive. Some mutual funds in this client's 401(k) exceeded 2.00%!

The Roth IRA

Since there are no overhead costs from a plan administrator like in a 401(k), Roth IRAs can operate less expensively. But arguably the biggest cost savings for these types of retirement accounts is the accessibility provided through a wider array of investment options. With an abundance of choices, investors can surely find mutual funds which are lower in cost resulting in significant savings over time.

Winner: The Roth IRA

I’ve highlighted only a few of the attributes of 401(k)s and Roth IRAs. Certainly some investors will put more weight on one attribute over another. The general consensus in the financial planning community is to contribute enough to your 401(k) to earn the full company match, then max out your Roth IRA (assuming you’re eligible), and direct any additional savings into your 401(k).

The final decision though--and which retirement account (or combination of accounts) you value the most given their attributes--is up to you.

Do you have a 401(k) through your employer? Have you also considered opening a Roth IRA? Which of the attributes of these two retirement accounts may have swayed your decision one way or the other? Let me know in the comments below!