401k (unmatched) vs. IRA

November 2, 2006 10:08 AM

Should I invest in an unmatched 401k first or IRA first? I know that if one's employer matches 401k contributions that it's important to make sure to take advantage of that. But I'm less clear about the advantages of an unmatched 401k vs. an IRA, for retirement investing. If, say, one were to want to invest $5000 income, would it make more sense to fund the full $4000 in the IRA (probably Roth, as we're in our 30s) before contributing to the 401k? Or should it all be in the 401k? (Generally speaking of course). I've tried to do a little reading around on this, but on this particular question I remain confused.
posted by mollymolo to work & money (12 comments total)

Here's the correct order:

1) Enough 401(k) to get all the matching possible.
2) Roth IRA, particularly if you're young
3) The rest of the 401(k) up to the maximum
posted by kindall at 10:49 AM on November 2, 2006 [1 favorite has favorites]

If you have a 401(k) you probably are not eligble for a deductible traditional IRA. That leaves you with either a non-deductible traditional IRA or a Roth IRA. Since both are non-deductible but only the Roth is tax free at withdrawal, the Roth the better deal. However there are income limits to Roth eligibility. The phase out starts at $95,000 for singles and $150,000 for marrieds. The general rule is:

1. first fund your 401(k) to the limit of your employer's matching contributions,
2. then fund your Roth,
3. then contribute any excess to your 401(k).

Since your emplorer does not make matching contributions you should skip step one and go to steps 2 and 3.
posted by JackFlash at 10:57 AM on November 2, 2006

The key factor is what your current marginal tax rate is today compared to what you expect your marginal tax rate to be at retirement. If you think that you will be at the same tax rate or a lower tax rate when you retire and everything else is equal, you would be better off to invest more now (tax free) and pay the tax at the end and should prefer the 401(k). If you believe that your tax rate will be higher at retirement, you would be better off to pay the tax now and go with with a Roth IRA.

In case that is unclear, remember that the $4,000 you invest in the Roth actually cost you $5,556 (if you are in the 28% tax bracket). You could afford to invest more in a 401(k) because it is as if you never earned that money from a tax perspective.

The other factor that might make a Roth more attractive is that you often have very limited investment options in a 401(k), which means that you could earn a better yield in a Roth. A Roth also has a bit more flexibility when you retire in terms of mandatory withdrawals.
posted by Lame_username at 11:08 AM on November 2, 2006

Lame_username is pretty well explaining why people are pointing out the 401k to match first, then Roth IRA order.

Another factor: penalties.

The Roth IRA allows penalty and tax-free withdrawals of contributions for any reason. But remember, once you've taken out that money, you don't have the option of replacing it. This is not the case with a 401k. You will be penalized if you withdraw your contributions.

Look into the penalties for both and understand how it fits into your lifestyle, should you ever have to use money during hardships.

Tax implications (front vs back-end) and penalties are the two major differences.

Lastly, there remember, there are no guarantees. The government might one day say, "oh, we'll tax a wee on the Roth." Just be aware that the game can change. I'm sure there'd be a stink though.
posted by pedantic at 11:33 AM on November 2, 2006

IANAAccountant, but my understanding is that if you put $1000 into a 401(k), you don't pay taxes on the $1000 now, but you pay taxes on both your original contribution and whatever it earns between now and when you withdraw it. However, if you put the same amount in a Roth, you pay taxes on the original $1000 now, but you pay no taxes when you withdraw it on either your original contribution or your earnings.

If I understand it correctly (and someone PLEASE correct me if I'm wrong), that means that even if you expect your tax rate at retirement to be lower than your current tax rate, it may still make sense to invest in a Roth rather than a traditional 401(k) or IRA because you'll avoid ever paying taxes on the account's investment earnings, which, if you've invested well, will be many times greater than your initial investment.
posted by decathecting at 12:13 PM on November 2, 2006

decathecting: This is definitely not the case

You can think of your 401(k) as an equation:
($ invested) * (1 - input tax rate) * (growth factor) * (1 - output tax rate)

$ invested speaks for itself

"input tax rate" is how much tax you pay going in. For a traditional 401(k)/IRA, this is 0%, for Roth investments this is probably something like 28%.

The "growth factor" is basically the compounded rate of return you got over the life of the investment. Note that you can compute this number without knowing how much money you started with - $100 at 5% over 40 years is exactly 10 times as much as $10 at 5% over 40 years.

The "output tax rate" is the same as the input tax rate, but in reverse (0 for Roth, non-zero for traditional)

This equation just uses multiplication, so as long as (input tax rate) = (output tax rate), it doesn't matter which is which because order doesn't matter when you multiply. There's no "earnings" vs "contribution" tax distinction for normal withdrawals; either you're taxed or you're not.
posted by 0xFCAF at 12:53 PM on November 2, 2006

If your 401(k) is unmatched, you are probably better off investing via a Roth IRA (noting what's been written above), especially if you have $4,000 sitting around. (Don't for get to keep 3-6 months in a cash equivalent for emergencies!)

One thing that weighs in favor of the 401(k) is the fact that your contributions would be taken automatically from your paycheck. That's a good thing you're not sure you're disciplined enough invest in an IRA on a regular basis.

By the way, it's usually considered advantageous to invest a small amount regularly (Dollar Cost Averaging) as opposed to amassing a sum an investing it once a year.

However, check into the fees in your 401(k). Many of them have additional fees. Sometimes they are a specific dollar amount. More frequently, they are a percentage taken off the top of your returns. Usually they are called asset management fees, asset fees, contract charges, etc. Your employer should be able to tell you what these are. If these fees plus the mutual fund expenses are less than what you would pay in your IRA, it's a good deal. However, they don't have to be. Smaller 401(k) plans frequently have to pay between 1%-2% over and above the mutual fund expenses.

What a 401(k) does frequently get you is access to A Shares without the loads and investment minimums.

For convenience, the 401(k) is hard to beat. You should just weigh that against the expenses. Ask youself, how much are you going to invest on a periodic basis. Then compare that to the purchase minimum at your IRA provider. It's usually around $250.

Ask you employer if they are going to implement a Roth option in the plan if you're thinking post-tax investing is the right direction for you.

If in doubt, just do something to get started. The sooner you begin to save, the better! Good luck.
posted by robabroad at 2:16 PM on November 2, 2006

Ox, I'm not sure I understand. Let me try with some numbers.

Say I invested $100 in a retirement account a few years ago, and that money has earned $100 since then, making my total retirement account worth $200. Now, I'm ready to retire and withdraw from that account. Let's say for the sake of argument that my tax rate has remained steady at 30%, so that I was paying the same tax rate when I put the money in as I am now when I'm ready to take it out.

If the retirement account is a traditional tax-deferred IRA or 401(k), I paid $0 in taxes on the $100 when I put it in the account, because my contribution was tax deductible. Now, when I take the money out of the account, my withdrawal from the account counts as income, which is taxed at 30%. So I pay $60 in taxes on the $200 that I withdraw from the account.

If the retirement account is a Roth, I paid $30 in taxes on the $100 that I originally put into the account. However, now that I'm ready to take the money out, my withdrawals are not taxable, which means that I owe $0 in taxes on my $200 withdrawal.

In the former case, I paid $60 in taxes. In the latter, I paid $30. In both cases, I put in $100 and withdrew $200 at retirement. Am I missing something here?
posted by decathecting at 2:16 PM on November 2, 2006

decathecting: You're not missing anything - you ended up with the same amount of money, which is the only thing that you care about. The tax amount only appears different because you're not taking the time value of money in to account.

In theory, the government is making the same return on its money as you are, so it would have done the same thing with the $30 that you did and ended up with $60 at the end. $30 "now" is worth $60 "later" in this scenario, so you actually did pay the same amount of tax.
posted by 0xFCAF at 2:34 PM on November 2, 2006

Okay, so basically, what I should do is either invest $100 in a Roth and pay $30 in taxes, or I should invest $130 in a traditional IRA and pay $0 in taxes, so that I can afford to pay the taxes on the growth later on. People who spend the money they save in taxes by investing in a tax-deferred vehicle will end up losing in the end, but people who invest their tax savings will end up breaking even.
posted by decathecting at 3:07 PM on November 2, 2006

Decathecting, the thing you missed in your example above is that you don't have $200 in your Roth account at the end because you only put in $70 at the beginning after paying taxes. That $70 doubles to $140 dollars in your example. So at the end you have $140 in your Roth, exactly the same as after paying $60 taxes on the $200 in your traditional IRA.

The point 0xFCAF makes is that it doesn't matter if you pay the taxes at the beginning or at the end, you still end up with the same amount of money assuming the tax rate is the same. If you pay at the beginning, you have less money that is compounding. If at the end, you have more gains but that is set off exactly by the higher taxes.
posted by JackFlash at 5:13 PM on November 2, 2006

HOWEVER, if the choice is between traditional IRA and Roth IRA, the Roth IRA does have the simple advantage that, since you are putting in after-tax dollars, you are actually putting in "more." Assuming a marginal tax rate of 25% and a maximum contribution of $4000, then putting $4000 (after tax) into a Roth IRA is equivalent to putting $5000 (before tax) into a traditional IRA and paying the taxes when you retire. Except you can't put $5000 into a traditional IRA, because the limit is $4000. So the Roth wins simply because you can contribute more.
posted by kindall at 6:35 PM on November 2, 2006