Roth IRA vs. Traditional IRA vs. 401k vs. Roth 401k

With so many investment vehicles for your retirement funds, which one makes the best sense for you?

Obviously, it varies based on your objectives, but there are definitely myriad variables to consider when choosing where to stash that retirement money. I'll highlight some of the generic differences that are typical in these types of articles (just google Roth vs. traditional IRA to find a plethora of articles and advice), but the main purpose of this post is to delineate some of the key differences that are inexplicably omitted or barely mentioned in those other articles.

For a great highlight of the differences, see Wikipedia's 401(k) IRA Matrix. Obviously, as always with Wikipedia, confirm with another source (IRS publications are linked on the page) that the information is correct. That matrix, though, certainly gives a good basis for comparison in a easy-to-read format that I've seen nowhere else. I'll also refer to a general 401k and traditional IRA both as "traditional" to simplify wording and avoid confusion. And there are certainly differences between the Traditional IRA and 401k (as well as the Roth 401k and Roth IRA) that should be investigated (consult the Wikipedia article) that I may gloss over for the sake of simplicity once again.

The Basics

First, let's go over the basics just so we're all on the same page. Essentially, the main difference is that the Roth versions are post-tax money; thus, taxes don't have to be paid later in life during normal distributions. On the other hand, a Traditional IRA (or 401k) is tax deferred and then taxes at the normal income bracket level during distributions (although technically a Traditional IRA is post tax money at first until your filing for that tax year comes up on April 15, at which point it becomes deferred). At the very simplest level, it's the difference between paying tax now versus paying it later. The traditional versions reduce your tax bill for the current year (assuming it's a 401k or deductible IRA; there are non-deductible Traditional IRAs as well that are suitable for high income investors to open and then immediately convert to a Roth), while the Roth versions will reduce your taxes later in life.

With that in mind, if you think your tax bracket will be higher when you take distributions (take your money out of the account during retirement), then it makes sense to put money in the Roth versions and use post-tax money (it's important to note that the Roth won't ever increase your tax bill, it just won't reduce it; while the traditional versions decrease tax liability now and increase it later). On the other hand, if you anticipate being a lower bracket during the distribution phase, then it makes sense to reduce your tax bill now and contribute to a traditional version and pay the taxes later.

Complicating these predictions is not only the unknown of your future income, but the unknown of government taxation protocols.  Because of the unknown, some financial planners espouse "tax diversification" - contributing to both types so that if you guess wrong, you aren't hit as hard. If your tax rate stays the same from contribution to distribution, then the Roth and Traditional versions will essentially have no difference on the bottom line (although there are certainly a variety of other differences).

In general, I like to recommend the Roth IRA (especially if the Traditional IRA is non-deductible due to exceeding AGI limits; again, open the Traditional IRA and immediately convert to a Roth if your AGI makes you ineligible to open a Roth IRA directly) to the majority of people for a variety of reasons which will be elaborated below. However, I also think that there's some logic behind tax diversification, and think a 50/50 split would be appropriate for most individuals.

On somewhat of a side note, the power of tax deferred compounding of assets (i.e. using retirement accounts) is remarkable. You should contribute as much as you can as early as you can to truly see the power of compounding and the savings you will have over the course of 40 years avoiding paying taxes to the IRS is astounding. See the graphic above to illustrate this key point.

Contributing to Retirement Plans

Getting back to the topic at hand, here's the general order I typically recommend investors to stash their retirement money:
  1. First, contribute to your employer's 401k plan up to the employer match. If they match 50% of the first 4% of your salary, for example, always contribute the full 4%. This is a free money; you can't get much better than that. Pay attention to vesting schedules to see when the money in the account actually "becomes yours." Note that all matching contributions are treated from a tax-perspective in the "traditional way." That is, even if you're only contributing to a Roth 401(k) (post-tax money), your employers' contributions will be tax deferred. That instantly gives you some of the tax-diversification I was earlier talking about.
  2. After getting to the maximum employer match, contribute as much to an IRA as you can. The maximum IRA contribution for 2009 is $5,000 a year if you are below age 50, and $6,000 if you are 50 or above (assuming you are eligible based on your MAGI). The reason I like putting this second segment of money into an IRA instead of a 401(k) is because of the exponentially more investment options you have with your own plan and the flexibility involved.  A Roth IRA is typically preferred since a Traditional IRA is only tax deductible if you are below a certain income limit and your employer does not offer an applicable retirement plan.
  3. If you make too much money to contribute to an IRA or you still have more money you want to shield from the IRS after reaching the maximum allowable in your IRA, the next place to put your money is in the 401(k) up to the allotted $16,500 (below 50) or $22,000 (50 and up). The limits for the 401(k) are much higher than the IRA, and these funds can later be rolled over into an IRA account (which I recommend to simplify things and also for the increased flexibility) upon termination of employment.
We now understand the basic differences between Roth and Traditional retirement accounts as well as the order in which to contribute (for what to invest in, see my Investing Advice for the Masses and Lazy Portfolios posts). To reiterate an important point, a 401(k) or IRA is not an investment in itself; it is an effective vehicle in which to hold investments. Thus, even if you play the game perfectly about your contributions and where to hold them, if you make poor investment choices, you won't fare well.

Along the same lines, financial advisers and commentators frequently talk about the importance of the contribution and accumulation phases of the retirement accounts, while completely neglecting the distribution phase. During a basketball game, do you only try in the first three quarters? No! The fourth quarter is where you put the pedal to the metal and see what you're truly made of. It determines the outcome of the basketball game. It's the same with retirement accounts. If you make lousy decisions during the distribution phase, your great decisions during the other phases won't mean as much. Of course, it's much easier to win the game in the fourth quarter if the first three quarters went very well.

The Roth IRA Advantages

Finally, let's discuss the positives of the Roth IRA that typical articles don't even mention that I find truly significant:
  • Contribution limits are effectively higher for the Roth. What? Didn't I just say above that for an IRA that limit is $5,000 (if under 50) for both types? Yes, that is true, but since the Roth contributions are post-tax money, the limit is $5,000 post-tax. In essence, if you're in the 25% tax bracket, it's like you're contributing $6,666 to a traditional account. (Not that the $1,666 is free money, just that you have an additional $1,666 to start your investments from that avoids the IRS for all those years). Roth accounts let you get more money into them and help your bottom line.

  • Keep all your money in the Roth IRA for yourself and for your children. Since you used post-tax money in the Roth account, the account balance that you see is what you'll get. Obviously, the Traditional IRA allowed you to avoid taxes earlier in life, but I like the added simplicity of seeing an account balance and knowing you get to keep it all. On top of this, in a Traditional IRA you are forced to begin distributions at 70 1/2, while a Roth IRA has no such forced distributions. Thus, if you are planning to leave an inheritance to your children, you not only get to avoid the IRS for even more years, but you'll actually know how much you're passing on! There are far too many times when children are thrilled with the balance of their rightful inheritances from a parent's retirement account only to be hit with HUGE tax liabilities. They don't know what hit them. Help your children avoid that and contribute to a Roth IRA. Even if you didn't contribute to the Roth version at the onset, you can easily rollover your traditional IRA to a Roth IRA and just pay taxes in the year of conversion. Likewise, you can rollover your 401(k) to a Traditional IRA, and then roll that over to a Roth IRA. Your children (and your aging pulse) will thank you for actually giving them the amount they anticipated.

  • But the most significant advantage of the Roth IRA over Traditional IRA that is hardly ever mentioned in articles is that all contributions to a Roth IRA may be withdrawn at any time for any reason penalty and tax-free. That is truly astounding! With the unpredictable game that is life being played, it's hard for certain people to contribute a lot of money towards retirement and not be allowed to see that money again for forty-some years when you turn 59 1/2. What if something happens that you need that money? (There are exceptions for education, medical expenses, and a home purchase in which you can withdraw money from non-Roth accounts without penalty). In normal circumstances, withdrawing money from a traditional retirement account early is tantamount to shooting yourself in the foot. Not only do you have to pay taxes, but you have to pay a 10% penalty. In those cases, it would have been better not having money in your retirement account at all. To avoid this doubt and uncertainty, contribute to a Roth without looking back! This is with a caveat: if you lack discipline and need to have your money inaccessible so that you won't touch it, maybe this positive is actually a negative for you. If you change your mind, you can always take out your contributions without any sort of penalty. It's important to note that you can only take out up to the amount contributed to the IRA. So, any income generated from your investments (which hopefully there is some) must remain in the retirement account until the appropriate time unless you want to pay the 10% penalty. Also note that a Roth 401(k) is slightly different than a Roth IRA and has more restrictions (hence why I earlier said I prefer the IRA due to increased flexibility). I have no idea why more articles don't emphasize this point. Life is unpredictable. Having the ability to "undo" something without being penalized is a huge benefit, although you certainly should strive to keep all your money in the retirement accounts due to the immense power of tax-deferred growth.  Note that a withdrawal from a Roth 401k is not the same.   You have to have the account opened for five years and the proportion of withdrawal must equal to the proportion of profits to contributions, which is then subject to 10% penalty if you're under 59 1/2 plus tax.  So, contributions from a Roth 401k cannot be easily at all as you're forced to wait 5 years and pay tax on some of it. 

    There you have it. A simple breakdown of some of the differences between these accounts, where I think it makes sense to put your money, and the advantages to the Roth IRA that are often overlooked. Good luck!
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