Should You Invest in a Roth IRA, Traditional IRA or 401k
Positive Cash Flow
We will assume that you have a job and you make more money than you spend. You have paid off your credit cards. You have put some money away for a rainy day. You have extra money coming in every paycheck. Congratulations, you are saving. Your income exceeds your expenses.
Saving vs. Investing
Let us talk about the difference between saving and investing. The distinction is important because the strategy you will employ will be different. If you have paid off the credit cards and have an emergency fund, you have already been saving for a while. You have put excess money away for a specific purpose. You can simply continue that behavior to meet the next goal such as buying a car or a home. Investing on the other hand is when you accumulate money for the specific purpose of getting a return on your money. The goal might be to replace your paycheck with investment earnings.
Your Money or Your Life
Vicki Robin uses the term financial independence when all your living expenses are covered by passive income from investments. We will adopt that here.
Tax Advantaged Investment Options
Let us take a moment to get familiar with the investment options, 401k, Roth IRA and traditional IRA. In some sense, Health Savings Accounts (HSAs) also fall in this category. What sets these apart from regular investment accounts is the way you pay taxes. These options are said to be tax advantaged accounts. The tax laws regulating them have been made in such a way as to encourage you to save by giving you tax incentives.
Regular investment accounts require you to pay tax on earnings in the year you receive them. You also have to pay tax on the gains when you sell investments that have increased in value. This is bad especially if it means that you end up in a higher tax bracket. If you are in the 15% tax bracket and the additional investment income pushes you into the 25% tax bracket, you get to keep only 75 cents for every dollar in that bracket instead of 85 cents. That might not sound like much of a difference, but imagine doing that for a lot of years on a much larger amount. Then, we are talking real money.
The traditional IRA lets you put money away without paying tax on it until you take it out. That means that the taxes on any earnings are also delayed. We say the taxes have been deferred.
The Roth IRA works in reverse. You pay tax on the money you put in, but pay no tax when you take it out. The earnings are tax free.
The 401k is similar to the traditional IRA. You delay paying taxes until you take the money out. There are some significant differences, though, and we will get into that a little later.
Health Savings Accounts were not designed for investing, but to help you pay medical bills. HSAs let you save money without paying taxes at all as long as you use it for medical expenses which most of us will sooner or later. Use it for any other purpose and HSAs behave much like other tax deferred accounts.
So which option is best? The short answer is that it depends. Of course, that is not very helpful, so let us look at the long answer.
If your employer offers a 401k plan, you will want to know if they match any portion of your contributions. Some employers will match as much as the first 3 to 6 percent of your income you contribute to your 401k plan. If you contribute $100, they may contribute maybe $50. That is the same as getting a 50% return on your money instantly. That beats even high interest credit cards, so if you have any of those left, it is OK to delay paying them off until you have fully exploited this option. A company match is hands down the best deal you can get. Start with that if it is available.
Choices Depend on Circumstances
What you should do next depends on your particular circumstances. The decision depends on when you need the money and your current and future tax bracket. Predicting the future can be difficult, so the best choice is probably to use all available options, but you will use them at different stages of your life. Tax deferred accounts like traditional IRAs, 401ks and HSAs work best if you are currently in a high tax bracket and you think your bracket will be lower or the same when you need the money. For most people, this tends to be somewhere in mid-life. A Roth IRA works best while you are still in the lower tax brackets and you think your bracket will be higher when you take the money out. This often tends to be in your early years.
The Roth IRA
There are some income restrictions for you to contribute to a Roth IRA, but they start at $117,000 for 2016. If you make that much, you may be better off with one of the other options. Roth IRAs work best for the lower end of the income scale in the 10% or 15% tax brackets. You can contribute up to $5,500. You will want to do that if at all possible. Due to the power of compound interest, over 35 years, a typical working lifespan, your $5,500 will grow to over $30,000 if invested at a modest 5% and that is tax free. Any amount, no matter how small, will make a huge difference for your long-term goals. The key is to get started as soon as possible.
The Roth IRA option has a few more advantages. First, since you have already paid tax on your contributions, you can take it out again at any time without penalty if you needed to. Because of that, you may be able to reduce your emergency fund and let the Roth IRA serve part of that purpose. Why would you do that? Because the return on money in the Roth IRA is tax free. The return on money in a regular account is not. It may take a little longer to access money in a Roth account, so you are still going to need a reserve you can access immediately. Only you can decide how much makes you comfortable based on your particular circumstances; how likely you are to get into an emergency and how bad it could get.
The Roth IRA is also an excellent choice if you plan to pass some of your assets to your heirs. It will be tax free for them too.
You can also access at least some for the earnings penalty free under certain circumstances such as for medium-term goals like a house or for higher education. You can continue to contribute to a Roth IRA for as long as you have earned income. However, you might want to stop once you get into the 25% tax bracket and consider one of the other options.
Traditional IRA and 401k
Traditional IRAs are basically designed for people who are not covered by a 401k plan. The contribution limit is the same as for a Roth IRA, $5,500, but may be reduced if you are covered by a 401k plan at work and your earnings are above certain limits. The limit for 401k contributions is $18,000.
Since the traditional IRA and the 401k are similar, which one should you choose? I say the 401k wins almost every time for several reasons. After all, the IRA was just meant to fill the gap when a 401k is unavailable.
In a 401k plan
- Contributions are automatic payroll deductions. It is far too easy to "forget" to contribute to an IRA.
- The contribution limit is $18,000 instead of $5,500.
- May allow loans.
The drawbacks of 401k plans are
- Limited number of investment options.
- Fees may be higher.
If you plan to make only a small contribution, you like to have unlimited investment options and the ability to borrow from the account is not important to you, go for the traditional IRA. Once you hit the $5,500 limit, switch to the 401k.
Beyond Tax Advantaged Options
It is possible to make non-deductible contributions to a traditional IRA should you hit the 401ks' upper limit and still want to save more. Withdrawing it, however, will be a record keeping nightmare because part of each withdrawal will be taxable and part will not.
One way to get around it is to roll your 401k into a so-called rollover IRA when you leave a job instead of rolling it over into the new employer's plan. Transfer it to the new employer only if the amount is small and/or you think you might need to borrow from it in the near future.
If you have some time to let it grow, you may be able to convert the rollover IRA to a Roth IRA where the earnings will grow tax free. You will have to pay tax on the amount, of course, but that may be a small price to pay for maybe decades of tax free earnings.
Another way is to open a regular brokerage account. Place securities like growth funds in it. Most of the earnings will be coming from increase in value, not from dividends. Just be sure to hold them for at least a year because long-term capital gains are taxed at a lower rate than short-term gains and dividends. Furthermore, you only pay tax on capital gains when you sell the securities, essentially deferring taxes till then. Inside your 401k account, shift a similar amount to income producing securities like bonds and dividend paying funds. These earnings will be taxed at the regular income rate when you withdraw them anyway, so it does not matter what type of account they are in. If you have a loss in your brokerage account, some of it may be used to off-set regular income and thus reduce your taxable income.
I hope the above information was useful to you. Please feel free to post your comments and ask questions in the comments section below. I will try my best to answer them all.