You decided to open a 401k. Finally! A smart decision today. But now they want to stump you with some investing jargon. Do you want traditional? Or a Roth? With fries?
Suddenly we don’t know what they are talking about. What is the difference between a traditional 401k and a Roth 401k? It’s simpler than you think.
In this post, we’ll solve the following questions:
- What’s the difference between an IRA and 401k
- What’s the difference between a Traditional IRA and a Roth IRA, and a Traditional 401k vs a Roth 401k
- Are the critics right that average people shouldn’t invest their retirement in the stock market
Now you’ll hear a lot of sometimes conflicting opinions about 401k accounts. The same with investing. Just realize that everyone has an opinion about everything. It doesn’t make them right. It’s easy to make cute slogans or generalizations, when you’re too lazy to find the truth.
This gets particularly true when you talk about taxes. Which is exactly what this issue boils down to. The difference between a traditional and a Roth 401k is its tax treatment.
A traditional 401k gets taxed when you withdraw. A Roth 401k gets taxed now.
That’s really it. Told you it’d be simple. The traditional 401k gets taxed when you retire, or if you withdraw early. It’s also known as tax deferred, meaning you get taxed later.
This means the money goes into your account without getting taxed now. They will deduct from your paycheck a pre-tax amount. That money evades Uncle Sam, and goes straight into your account. You pay no income taxes on that money. But you will get taxed on withdrawal.
A Roth 401k does the opposite. You get taxed now, and then your account grows tax free afterwards.
The Roth 401k is very appealing if you plan to be in a higher tax bracket when you retire. Keep in mind that when you retire you probably won’t be making an income. But if you have substantial investments – which you should – then the income from those investments will be taxed.
So the question comes down to whether your future income (investment income, social security, etc.) will be in a higher tax bracket than your current income and tax bracket.
If your future income will be higher, go Roth. If not, get a traditional 401k.
I personally picked a Roth. I’m optimistic and confident in my future (you could say wildly optimistic). I know nothing is for certain, but I’m ok with that. I’ll accept the risk that tax laws could change, or that I fall in a lower tax bracket.
Ultimately, it’s all up to you.
Remember what I said above about conflicting opinions? It seems like a traditional 401k isn’t being taxed and some people believe this. You won’t see a high tax bill now, you might even forget about the tax. But contrary to this belief, it will be taxed.
You’re not saving on taxes with a traditional 401k, you are just deferring them.
Please keep in mind I am not a tax advisor, and I don’t plan to be. If you have specifics questions with taxes you should see a professional.
The tax code is extremely confusing, long. It’s also updated every year. I’m guessing you don’t have time to keep up. Money spent on tax advice is usually money well spent, if you have any concerns.
It’s great that you’re starting a 401k. It’s a great first step. You should also additionally fund an IRA, and look into managing your own investments.
Riches don’t come to the lazy.
Opening a 401k vs an IRA
Another great email from a reader. This one has to do with the common investor’s dilemma: IRA vs. 401k.
With that said, I’m not interested in a financial adviser either. I want to learn. I want to become an investor. A white coat investor. So as you can tell, your ebook was an amazing find for me. I heard about you through the Money Tree Podcast interview. I’m glad I stumbled upon it.
Now to my question. I want to be an Intelligent Investor (I’ve ordered that book too from amazon, it’s on its way.) I know I have an amazing amount to learn, but I have an idea I wanted to run past you.
For the next whatever number of years I need to plan my budget to not only include my living expenses, but repaying my student loans as well. With that said I wanted to do the following:
Take 10% of every paycheck and use it for investments (to practice the dollar cost averaging idea and build my portfolio.) 5% I wanted to put into an IRA of some type or perhaps my work’s 401k. And another 5% into savings for heck of just plain practicing the habit of conserving (while it might not ultimately serve me well as investing might.)
The question is, do you think I should invest in an IRA like a 401k? I’ve been doing some research and some critics are calling it a horrible idea pointing out to the many who lost their retirement savings because of the market crash and also because of the mediocre investing options these plans supposedly offer.
Are these critics right or is it the fault of the investor for not diversifying their assets and knowing how to work the market?”
Ah, the classic IRA vs. 401k dilemma. There’s a couple of things to consider.
But first, understand that I am not a financial planner. I’m just a regular guy who happens to have a little more experience with investing than you do, the average beginner.
Secondly, everyone’s situation is different, and so everyone’s personal answer is going to be different. Pretty much every single company’s 401k plan is unique and different than most every other company, so make sure you are diligent and research the differences.
Now that we put that out of the way, here’s what you need to know about the IRA vs. 401k. With the IRA, you have complete control of your investments. You can buy any stock, bond, or even a piece of real estate with your IRA.
The 401k is not as flexible. With most company provided 401k plans out there, you have a limited choice of funds to choose from. Obviously this is detrimental and unappealing, especially to the do-it-yourself investor.
This one difference is a big one. What if you are a decent stock picker, and could’ve easily outperformed the subpar mutual funds a 401k would offer? Or what if you are a prudent investor in low-cost index funds, but only high fee loaded funds are available to choose from?
Those limitations of the 401k can make a big difference in your returns, and this is why the IRA is almost always preferred. HOWEVER, there’s an important caveat to this.
What the 401k can offer people that an IRA can’t is a company match. The company match is essentially free money. What the company usually does is “match” the amount of money you contribute to your 401k (up to a certain percentage), and the money (after vesting) will be added to your 401k balance to then grow some more. You can think of a 401k company match as giving you a 100% return on your money, so it’s definitely worth doing.
Now we see why people get confused on the IRA vs. 401k. Sure, flexibility of the IRA is nice, but the difference in returns that you can get from outperformance will probably only be a couple of percentage points. Compare that to a company match 401k where you are getting a 100% gain on a full match.
How do you pick?
Sample Priority List for Retirement Savings
The financial guru Dave Ramsey, who I really respect and am inspired by, suggests doing the following when it comes to the IRA vs. 401k discussion:
1. Contribute up to the maximum percentage of company match for the 401k
2. Fully fund a Roth IRA (to the annual limit)
3. Use the rest of your money to go into your 401k
I agree with this logic. You really should fully take advantage of the company match, and so that’s first priority.
Next you’ll want to fully fund a Roth IRA. The downside to the IRA is that the government has put a limit on how much you can contribute to it each year. The limits change as often as tax laws do (yearly), so be sure to run a quick check on Google to see what it is. As I am writing this in 2014, the limit is $5,500 for singles and $11,000 for married ($5.5k each).
Also, you can’t qualify for an IRA if you make over a certain amount each year. In 2014, this amount is $181,000 for filing married. Sorry big income earners, the government doesn’t like you.
Finally, use the rest of your investing allocation into the 401k for its tax sheltered advantages. Dave recommends 15% of your income towards retirement if you are debt-free, and I’ve often encouraged at least 10%. So just use the priority above and you’ll maximize your dollars.
Oh, and as for the critics, they are just noise.