401K vs Roth IRA – Which Should You Invest In?

by kristine on November 3, 2011

The Roth IRA vs 401K Debate

There are many factors to consider when determining whether to invest in a 401k vs a Roth IRA.  Both retirement plans have benefits to offer. If your budget allows, it is best to invest in both a 401k through your employer and a Roth IRA on your own. However, that is not financially feasible for many people, so you may find yourself wondering whether one is better than the other.

A Quick Primer on the 401K

Most people are familiar with 401K plans, a retirement plan offered by many employers. With a 401K, you get to elect a percentage of your salary to save and invest, and that part of your salary goes into your 401k before it is taxed, which helps reduce the taxes you pay on your income tax return.

Historically, companies have often matched the amount you save for retirement. For example, if you invested four percent of your salary into your 401k, your company might also contribute four percent on your behalf. Financial planners often refer to the company match as “free money” because it is compensation that your employer is providing above and beyond your regular salary.

While traditionally 401K plans have been pre-tax, some companies also allow after-tax contributions or even Roth 401K options.

How a Roth IRA is Different

A Roth IRA is a little different than the traditional employer sponsored retirement plan. A Roth IRA is a retirement account you set up on your own, with an initial deposit and then a regular contribution which you determine. You need to have earned income in order to contribute to a Roth IRA, even though it’s not an employer sponsored account.

The money you put into a Roth IRA is already taxed, so you don’t get an immediate tax benefit like you do with a 401K. However, one of the greatest features of the Roth IRA is that you will not have to pay tax on withdrawals from your Roth IRA, as long as the distribution is “qualified”.

However, another benefit of the Roth IRA is that you can take out any contributions that you have made without taxes or penalties. So, if you have a balance in your Roth IRA of $30,000, and $24,000 of that is based on contributions you have made, you can take the full $24,000 out at any time without penalty. You can’t withdraw the earnings until you reach age 59-1/2, but you always have access to your contributions.

Once you reach age 59 1/2 and your Roth IRA has been in existence for at least five years, then you can withdraw contributions and earnings without paying any taxes or penalties.

Which One is Right For You?  How About Both…

So which retirement account is best for you?  With profits dwindling and the cost of running a business growing, many companies are taking away the matching 401k contribution, making 401K plans less appealing than they have been. On the other hand, 401K plans make saving easy since the money comes right out of your paycheck, and they do offer valuable tax deferral so they can still be beneficial even if you don’t get a company match.

Roth IRAs are very flexible – thanks to the rule that allows you to take your contributions out at any time without paying any taxes or penalties – which makes them great not only for saving for retirement but for other financial goals as well.  Many people use Roth IRAs to save for their first home, to pay for college, or even as their emergency fund.  And the tax free withdrawals (for qualified distributions) is hard to pass up, making Roth IRAs valuable investment vehicles as well.

In fact, both plans have many benefits, and you may benefit from having both types of accounts instead of choosing just one.  With tax laws constantly changing a strategy you might consider is to keep your 401k in place, but open a Roth IRA as well.  This will allow you to diversify your portfolio from a tax standpoint (just like you do to reduce investment risk), and also provides different options for how to manage your money and when to withdraw it after you retire.

If you cannot do both, and are unsure of which plan is best for you, talk to a financial planner. A qualified professional can help you decide the 401k vs Roth IRA dilemma.

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