You’ve got a limited pool of money to put aside for retirement. How do you choose whether a 401(k) or Roth IRA is best for you?
Find out now: How should I save for retirement?
Taxing Yourself: Now or Later
The main difference comes down to taxes. With a 401(k), you contribute untaxed money and pay income tax when you start pulling money out during retirement. Traditional IRAs, or Individual Retirement Arrangements, are similar, with some exceptions.
Roth IRAs are different: You contribute money that’s already been taxed, and when it comes time to withdraw money, you don’t pay any more. That also means you never owe tax on your investment gains in a Roth.
The Myths and Reality of Deferred Taxes
One of the key ideas underlying a 401(k) is that most people drop into a lower tax bracket when they retire and stop earning a salary, so that when they pull money from their 401(k) they’re paying less tax than they would have paid on that money while working.
But that may no longer be true for most people. Tax rates are historically low now, and the U.S. budget deficit is big. Some say tax rates are bound to rise eventually to help reduce the deficit. Still, betting on what the U.S. Congress may do in the future is a losing bet. Nobody really knows what’s going to happen to tax rates. If your educated guess is that your rate when you retire will be higher than it is now, it makes sense to consider a Roth.
Also, if you’re smart about saving — you save enough, you invest wisely — your annual income may not change all that much when you move from “employed” to “retired.” That may mean you stay in the same tax bracket. Then a Roth may be your best bet now.
The 401(k): Game, Set, Employer Match
A major benefit of 401(k)s is the employer match — free money paid by your employer into your account, with the amount usually figured as a percentage of your contribution. Even if you decide a Roth IRA is best, it makes sense to contribute to your 401(k) at least enough to get that match, if your employer offers it.
Especially if you work at a company that offers an employer match, 401(k)s have plenty going for them. There’s that match, plus:
• You can contribute more. In 2012, the maximum annual contribution to a 401(k) is $17,000, versus $5,000 to a Roth for people under age 50.
• Saving pre-tax makes it easier to put in more now. For example, you can put $5,000 today into a 401(k) or a Roth, but with the Roth, you’ll pay taxes now. If you’re in the 25% tax bracket, that’s about $6,700 total out of pocket now.
Roth IRA Benefits
• You pay your tax bill now, which is a plus if your tax rate is still low.
• You can withdraw your contributions (but not your investment earnings) at any time, for any reason, without penalty.
• Unlike with a 401(k), you don’t have to start distributions when you’re 70 1/2.
Still confused? There’s an easy out: Put money in both.