What is a reason that a Roth IRA is be better to put money into if I'm not maxing out my 401k?
June 30, 2011 10:33 AM Subscribe
What is a reason that a Roth IRA is be better to put money into if I'm not maxing out my 401k?
FYI, I'm currently not maxing out my 401k (yes, ideally I would like to). Recently I had a free consultation with with a financial advisor through my bank who said that getting a Roth IRA is a bit better than putting that money into the 401k. He made a bunch of scribbles and gave me an explanation, but I didn't understand all of it. Can you help me understand why?
FYI, I'm currently not maxing out my 401k (yes, ideally I would like to). Recently I had a free consultation with with a financial advisor through my bank who said that getting a Roth IRA is a bit better than putting that money into the 401k. He made a bunch of scribbles and gave me an explanation, but I didn't understand all of it. Can you help me understand why?
Best answer: You put money into a Roth IRA post-tax, so when you take money back out, you don't have to pay income taxes on it. 401k contributions are made pre-tax, so you do have to pay income tax when you withdraw the money. In retirement, when you're on a fixed income, it would be nice to pay as little income tax as possible. That's probably the main reason he's recommending a Roth IRA.
posted by something something at 10:39 AM on June 30, 2011 [2 favorites]
posted by something something at 10:39 AM on June 30, 2011 [2 favorites]
There's a lot of information about this out there if you Google it, but the basic two advantages of a Roth over a 401(K) are:
(1) You have more investment options in a Roth IRA
and
(2) You don't pay taxes on withdrawals/capital gains from your Roth IRA.
posted by griseus at 10:40 AM on June 30, 2011 [1 favorite]
(1) You have more investment options in a Roth IRA
and
(2) You don't pay taxes on withdrawals/capital gains from your Roth IRA.
posted by griseus at 10:40 AM on June 30, 2011 [1 favorite]
Response by poster: thanks everybody! yes, I have seen the wealth of google information and wanted a more direct answer! thanks for helpin a newb out.
posted by elif at 10:42 AM on June 30, 2011
posted by elif at 10:42 AM on June 30, 2011
When you withdraw money from a Roth IRA at retirement because you invested it after taxes, your withdrawal is tax-free.
A 401K investment is done before taxes, and withdrawal is taxed at retirement.
You should always invest in a 401k if you receive employer matching as it is apart of your benefits and double your money when investing. Typically that is 6%, where you invest 6% of your salary and your company will match that 6% investment. I hope your financial adviser mentioned that key part. If not, check to make sure your financial adviser has fiduciary responsibility to you.
posted by BuffaloChickenWing at 10:44 AM on June 30, 2011
A 401K investment is done before taxes, and withdrawal is taxed at retirement.
You should always invest in a 401k if you receive employer matching as it is apart of your benefits and double your money when investing. Typically that is 6%, where you invest 6% of your salary and your company will match that 6% investment. I hope your financial adviser mentioned that key part. If not, check to make sure your financial adviser has fiduciary responsibility to you.
posted by BuffaloChickenWing at 10:44 AM on June 30, 2011
Another consideration is that contribution limits are much lower on a Roth IRA (5k) vs. a 401k (16.5k + match). If you do decide that the Roth was a good idea, it's not very easy to "catch up" to your 401k balance.
posted by smackfu at 10:47 AM on June 30, 2011
posted by smackfu at 10:47 AM on June 30, 2011
Best answer: Is your employer matching? If so you should put as much money into your 401K as you can to get the match.
I think the argument for a Roth is a sort of bet hedging. The money you put into a regular IRA/401k is pre-tax, but you are taxed when you pull it out. The money you put into a Roth is taxed now, but not when you pull it out. One defers taxes now and the other defers it later.
Here's the key - you will have more money then than you do now. I'd rather defer the tax on the big amount I pull out than on the small amount I put in (this assumes that you can put int he same amount either way. Given the tax incentives this may not be true). Of course, the odds of the tax code changing between now and retirement are probably about, oooooh, I'd say 100%. I don't know what this will mean for retirement accounts. No one does. Hence the bet hedging.
One other point to remember is that the Roth has an income cap. Earn more than a certain amount and you can't contribute to a Roth (although there is a wierd dodge whereby you can convert a regular IRA to a Roth even if you are over the income cap). Contribute now, because you might not be able to contribute a few years down the line when you are pulling in the big bucks.
posted by It's Never Lurgi at 10:50 AM on June 30, 2011 [2 favorites]
I think the argument for a Roth is a sort of bet hedging. The money you put into a regular IRA/401k is pre-tax, but you are taxed when you pull it out. The money you put into a Roth is taxed now, but not when you pull it out. One defers taxes now and the other defers it later.
Here's the key - you will have more money then than you do now. I'd rather defer the tax on the big amount I pull out than on the small amount I put in (this assumes that you can put int he same amount either way. Given the tax incentives this may not be true). Of course, the odds of the tax code changing between now and retirement are probably about, oooooh, I'd say 100%. I don't know what this will mean for retirement accounts. No one does. Hence the bet hedging.
One other point to remember is that the Roth has an income cap. Earn more than a certain amount and you can't contribute to a Roth (although there is a wierd dodge whereby you can convert a regular IRA to a Roth even if you are over the income cap). Contribute now, because you might not be able to contribute a few years down the line when you are pulling in the big bucks.
posted by It's Never Lurgi at 10:50 AM on June 30, 2011 [2 favorites]
A lot of people have given definitions of how the Roth differs, but the easiest way I believe to think about this situation is to think of it as tax diversity. If you invest with a blend of pre-tax (401k) and post-tax (roth) money then later at retirements you will have some more options available to you. If you expect tax rates to rise, pull from the 401k fund and let the roth build up.
This is just one example. Additional benefits of the Roth is that you aren't required to take distributions at age 70.5. You can let it ride longer. Also, the inheritance rules are generous to avoid taxes on it. All of this could change but in decades to come the Roth will likely still have some tax advantages over the 401k/IRA accounts.
posted by dgran at 10:52 AM on June 30, 2011
This is just one example. Additional benefits of the Roth is that you aren't required to take distributions at age 70.5. You can let it ride longer. Also, the inheritance rules are generous to avoid taxes on it. All of this could change but in decades to come the Roth will likely still have some tax advantages over the 401k/IRA accounts.
posted by dgran at 10:52 AM on June 30, 2011
On the other hand, if your company matches your 401(k) contributions, make sure to find out how vesting works with them. Where I work, you have to have been here for 5 years to be 100% vested in the employee match. If you don't see yourself sticking around to 100% vesting, going for that match might be less worthwhile to you.
posted by litnerd at 10:53 AM on June 30, 2011
posted by litnerd at 10:53 AM on June 30, 2011
The choice between a Roth-IRA and a traditional IRA or 401K is actually quite complicated. The simple version is that if you believe your current tax rate is higher than the tax rate you'll have in retirement, then a traditional IRA or 401K is preferable; you'd rather save the taxes now and pay them later. If you believe your tax bracket will be higher when you retire, then it is better to use the Roth; you'd rather pay the taxes now and save them later.
Also, many 401-K's have a match from the company, which obviously makes them better than either form of IRA.
All that said, I'm not your financial advisor so you shouldn't trust me. But make sure you really understand what your financial advisor is telling you.
posted by alms at 10:55 AM on June 30, 2011 [1 favorite]
Also, many 401-K's have a match from the company, which obviously makes them better than either form of IRA.
All that said, I'm not your financial advisor so you shouldn't trust me. But make sure you really understand what your financial advisor is telling you.
posted by alms at 10:55 AM on June 30, 2011 [1 favorite]
Response by poster: @It's Never Lurgi, thanks for such a helpful response! Out of curiosity's sake, do you know what the income cap is where you can't contribute to a Roth any longer?
posted by elif at 10:59 AM on June 30, 2011
posted by elif at 10:59 AM on June 30, 2011
IANA Financial Planner, but I also think that you can withdraw your principle from a Roth without a penalty; so it can act a bit like a savings account (vs. a 401k where you can take a loan, but it's almost always a bad idea to do so).
posted by MikeKD at 11:01 AM on June 30, 2011 [1 favorite]
posted by MikeKD at 11:01 AM on June 30, 2011 [1 favorite]
Another reason to invest in a Roth is 401K vesting. Even if your employer is making a matching contribution you may not actually get to keep that until you are fully vested. This can take up to 5 years depending on company policy.
posted by Gungho at 11:02 AM on June 30, 2011
posted by Gungho at 11:02 AM on June 30, 2011
Best answer: One other point that I haven't seen mentioned is the potential difference in fees/expenses between a Roth IRA and a 401(k). With a Roth IRA, you can choose any custodian (such as a no fee/low expense Vanguard) while with a 401(k) you are at the mercy of your company's provider. Some companies are knowledgeable and care about their 401(k) benefits, but others don't care and employees are given terrible options that will charge 1-2% annually. Before you decide either way, you need to research the fees and expenses associated with the 401(k). And be careful because many providers go out of their way to obscure this information.
posted by Durin's Bane at 11:04 AM on June 30, 2011 [1 favorite]
posted by Durin's Bane at 11:04 AM on June 30, 2011 [1 favorite]
phases out between 107k and 122k
(its all about betting on tax rates.)
posted by JPD at 11:05 AM on June 30, 2011
(its all about betting on tax rates.)
posted by JPD at 11:05 AM on June 30, 2011
Just wanted to reiterate what dgran said because it hasn't really been highlighted strongly here. With the 401k you will be forced to take distributions once you hit a certain age (70.5). With the Roth you are not forced to take distributions and can leave it to your heirs if you do not need it. This can help avoid estate taxes to some extent.
posted by cmm at 11:10 AM on June 30, 2011
posted by cmm at 11:10 AM on June 30, 2011
Best answer: I also think that you can withdraw your principle from a Roth without a penalty; so it can act a bit like a savings account (vs. a 401k where you can take a loan, but it's almost always a bad idea to do so).
Right, I don't think people mention this enough when they are talking about the difference. If you have $1000 taken out of your paycheck to be put in your 401k, and for some reason you need to get that money back before retirement, you have to pay taxes on the $1000 as income and on top of that you have to pay a 10% penalty. If you put $1000 of post-tax money into a Roth IRA, you can always take the $1000 out without paying taxes or paying any sort of penalty. So your Roth IRA can act as a sort of emergency fund of last resort. Since there are free Roth IRA accounts exist and you can invest your money in something safe like a money market fund, it might make sense to open a Roth IRA as a tax-free rainy day savings account even if you don't plan on using it as a major part of your retirement investments.
posted by burnmp3s at 11:51 AM on June 30, 2011 [1 favorite]
Right, I don't think people mention this enough when they are talking about the difference. If you have $1000 taken out of your paycheck to be put in your 401k, and for some reason you need to get that money back before retirement, you have to pay taxes on the $1000 as income and on top of that you have to pay a 10% penalty. If you put $1000 of post-tax money into a Roth IRA, you can always take the $1000 out without paying taxes or paying any sort of penalty. So your Roth IRA can act as a sort of emergency fund of last resort. Since there are free Roth IRA accounts exist and you can invest your money in something safe like a money market fund, it might make sense to open a Roth IRA as a tax-free rainy day savings account even if you don't plan on using it as a major part of your retirement investments.
posted by burnmp3s at 11:51 AM on June 30, 2011 [1 favorite]
Is your employer matching? If so you should put as much money into your 401K as you can to get the match.
Maybe. My employer's match for my 403b is a whopping $20 per pay period. If the fund choice was bad or the administrative fee high enough it could be possible for me to lose more money that way than I'd gain. You need to examine the tradeoffs.
I don't see an explicit mention of it above, but another big part of the Roth tradeoff is your age, or rather how long you'll be paying in. The longer you have for your money to appreciate the more likely it is to be a better choice.
As far as the ability to raid the Roth without penalty I'd call that a flaw, not a positive. The vast majority of retirement fund raiding never gets paid back. Until you retire that money should be considered just as gone as if you'd already spent it. Making it hurt to do the wrong thing helps a lot of people to make a choice they won't make without pain.
posted by phearlez at 11:57 AM on June 30, 2011
Maybe. My employer's match for my 403b is a whopping $20 per pay period. If the fund choice was bad or the administrative fee high enough it could be possible for me to lose more money that way than I'd gain. You need to examine the tradeoffs.
I don't see an explicit mention of it above, but another big part of the Roth tradeoff is your age, or rather how long you'll be paying in. The longer you have for your money to appreciate the more likely it is to be a better choice.
As far as the ability to raid the Roth without penalty I'd call that a flaw, not a positive. The vast majority of retirement fund raiding never gets paid back. Until you retire that money should be considered just as gone as if you'd already spent it. Making it hurt to do the wrong thing helps a lot of people to make a choice they won't make without pain.
posted by phearlez at 11:57 AM on June 30, 2011
I don't know how widely available the option is, but my company has started offereing an post tax 401(k) option this year that works like a Roth IRA.
posted by garlic at 12:23 PM on June 30, 2011
posted by garlic at 12:23 PM on June 30, 2011
It is dangerous to have *all* of your retirement in one savings account-look at Enron. I have both a 401K AND a Roth IRA just to safeguard.
posted by Frosted Cactus at 7:27 AM on July 1, 2011
posted by Frosted Cactus at 7:27 AM on July 1, 2011
For those of you who would like to contribute to a Roth but can't because of the income cap, it turns out that you actually can. It is legal to convert a regular IRA into a Roth regardless of how much money you make. You have to pay taxes on whatever money hasn't already been taxed and this might be substantial for an IRA that has been around for a while, but you can always open a new IRA, fund it, and then convert it immediately.
No, I'm not kidding. If you are over the income cap then you can create a Roth IRA by creating a regular IRA, wearing the magical Hat of Loopholes, chanting TIPRA 2005, and converting it into a Roth. AFAIK you don't have to have the IRA for any particular amount of time, so you could open the IRA and convert it on the same day. But don't even think about opening a Roth directly if you are over the income limit. That would be illegal. Naughty.
Please, please, please check with a financial advisor or, really, anyone other than me before doing this or thinking about this. The amount of tax you pay, the time over which you have to pay it, and where you pay it from are all subject to change and this may or may not be a good deal for you. But if you have not opened a Roth because you are above the income limit (lucky you), you now have that option.
posted by It's Never Lurgi at 10:38 AM on July 1, 2011 [1 favorite]
No, I'm not kidding. If you are over the income cap then you can create a Roth IRA by creating a regular IRA, wearing the magical Hat of Loopholes, chanting TIPRA 2005, and converting it into a Roth. AFAIK you don't have to have the IRA for any particular amount of time, so you could open the IRA and convert it on the same day. But don't even think about opening a Roth directly if you are over the income limit. That would be illegal. Naughty.
Please, please, please check with a financial advisor or, really, anyone other than me before doing this or thinking about this. The amount of tax you pay, the time over which you have to pay it, and where you pay it from are all subject to change and this may or may not be a good deal for you. But if you have not opened a Roth because you are above the income limit (lucky you), you now have that option.
posted by It's Never Lurgi at 10:38 AM on July 1, 2011 [1 favorite]
A Roth is better if you assume you'll be in a higher tax bracket when you remove your taxes.
A standard 401k is better if you assume your tax bracket will decrease after you retire.
For people out of their 20s, a 401k is probably more appropriate.
For people making "starter salaries", who expect to rise in income significantly, a Roth is appropriate.
Mid-career, those people should probably still switch to standard Roths. Few retirees pay higher taxes than they did as wage earners.
And you should try harder to max out your 401k. It's as simple as signing a form. Do it tomorrow.
posted by IAmBroom at 5:34 PM on July 2, 2011
A standard 401k is better if you assume your tax bracket will decrease after you retire.
For people out of their 20s, a 401k is probably more appropriate.
For people making "starter salaries", who expect to rise in income significantly, a Roth is appropriate.
Mid-career, those people should probably still switch to standard Roths. Few retirees pay higher taxes than they did as wage earners.
And you should try harder to max out your 401k. It's as simple as signing a form. Do it tomorrow.
posted by IAmBroom at 5:34 PM on July 2, 2011
This thread is closed to new comments.
posted by litnerd at 10:38 AM on June 30, 2011