401k vs Roth: Which is best for you?

12 minutes

photo courtesy of girls just wanna have funds

 

“Hang in there, retirement is only 30 years away!” Workplace graffiti
401k is one of the most common words used when discussing retirement. But what do we really know about them? Most employers offer them to their employees as a means of providing a benefit to their employees. It is also a means of retirement for many workers.

Let’s lay out some stats for you so you get a framework of the influence a 401k has on our retirement.

Total value of assets held in a 401k   $4.5 Trillion

  • Percentage of assets held in a 401k    18%
  • Total number of participants in a 401k    52,500,000
  • Percent of works that participate   81%
  • Average percent of salary contributed   6.8%
  • Percent of assets held in a mutual fund   64%

The average match of company contributions to 401k plans is 2.7%.

Let’s spend a little time to layout what a 401k is and how it works. Then we will spend some time comparing it to a Roth IRA.

 

What is a 401k?

 

A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.”   Wall Street Journal

The 401k was established in 1978 and has grown to become the most popular type of employer-sponsored retirement plan out there.

Millions of workers rely on their 401k for their retirement plans. It also a vehicle for companies to distribute stock options to their employees.

By definition, a 401k plan is an arrangement that allows the employee to defer a percentage of their salary to the 401k. The amount is usually not taxable until the employee until it is withdrawn or distributed from the plan.

Some plans allow the contributions to their 401k to be made on an after-tax basis. This is known as a Roth 401k plan and these amounts are tax-free on withdrawal.

The 401k is considered a defined-contribution plan. This means that the accounts balance is defined by the contributions to the plan as well as the performance of the investments.

The employer is not required to make a contribution, but most employers wisely choose to match a percentage of their employee’s contributions. This is based on a percentage of their gross pay.

This is free money and it is a sin to pass this up. Regardless of the amount that your company offers, TAKE IT!!! My employers offer a 6% match, which is awesome. I am saddened on a daily basis when I hear that people are not taking advantage of this option.

Contribution limits for the 401k for 2016. Will be the same in 2017

 

  • Maximum that can be contributed is $18,000 annually
  • If you are 50 or older you can make catch-up contributions of $6000 annually
  • The maximum allowable for joint employee/employer contributions is $53,000 or $54,000 (2017). This includes employer match, nonelective contributions, and profit-sharing contributions.

Let’s talk a little bit about distribution rules. The rules for distribution differ from those of an IRA. The money inside an IRA and 401k grow tax-deferred. But a difference arises where with an IRA you can access the money at any time. With a 401k a triggering event must occur for a distribution to be made from the 401k plan. The assets within the 401k can only be distributed in these circumstances.

 

  • Upon the employee’s death, retirement, disability or separation of service from the employer.
  • Upon the employee’s attainment of age 59 ½
  • When the employee experiences a hardship as defined under the plan, provided the plan allows for hardships

 

Required minimum distributions are required to begin at 70 ½ unless the employee is still employed and the plan allows rmds to be put off until retirement. Distributions will be considered ordinary income and assessed a 10% penalty for early distribution if done before the age of 59 ½ unless an exception applies. Exceptions include the following:

 

  • The distributions occur after the death or disability of the employee
  • The distributions occur after the employee separates from service, providing the separation occurs during or after the calendar year that the employee attains age 55.
  • The distribution is made to an alternate payee under a qualified domestic relations order
  • The employee has deductible medical expenses exceeding 10% of adjusted gross income
  • The distributions are taken as a series of substantially equal periodic payments over the participant’s life or the joint lives of the participant and beneficiary.
  • The distribution represents a timely correction of excess contributions or deferrals.
  • The distribution is the result of an IRS levy on the employee’s account.
  • The distribution is not taxable

 

The exceptions for higher-education and first time home buyer are only for an IRA. Sorry.

Another option for access to your funds would be a plan loan. This is an option that is available to those that their plans allow. It is a loan that you are able to borrow up to 50% of your vested balance and can’t exceed $50,000. There is typically a 5 year payback period.

The interest rate must be comparable to most loans from financial institutions. Any unpaid balance at the end of the term will be considered a distribution and will be taxed and potentially penalized accordingly.

Please explore all other options before considering this as a way to access funds. In addition to the possible fees and penalties you also have that money not earning interest for you during that time. This could be extremely expensive for you in the long run. With the power of compounding, that money could increase exponentially and when you take it out of the 401k as a loan it is now not working for you.

401ks have income limitations to them. If you are a high-income earner, meaning over $200,000 a year. Let’s say you earn $550,000 a year. You are only able to consider the first $265,000 for contributions towards the 401k. This will rise to $270,000 for 2017.  Employers can offer nonqualified plans, like a deferred compensation or an executive bonus plan to provide other options for additional retirement savings.

401k plans will continue to be the backbone of retirement plans here in the US for many years to come. This has been a brief overlay of the plans. Every employer that offers them will have specific details on their plans available to their employees. If you have any questions you can discuss them with your plan provider or reach out to me.

 

What is a Roth?

A Roth is a retirement plan that is after-tax money. Meaning that when you make a contribution from your paycheck it is coming after the taxes have already been deducted.

The advantage to this is that you will never have to pay taxes on those contributions ever. This means that when you start withdrawing the money during your retirement you will not have to pay Uncle Sam for that money because he’s already gotten his share.

You will be responsible for taxes on any gains during its time in the Roth and of course, any capital gains made as well. Another advantage to the Roth is no mandatory distributions when you reach 70 ½ or any age. You can start distributions any time you want after age 59 ½.

These are the main points of a Roth IRA. We discussed this account in great detail here. Please refer to that post if you want more information.

 

401k vs Roth

First, let’s talk about how a 401k is set up. You have the option when you start contributing to your 401k of what type of account you would like to have. You can use either the Traditional or Roth or the combination of both.

When your contributions are made they will be taken from your paycheck accordingly, based on the instructions you decide upon. The money will be withheld from your paycheck either before tax or after tax, depending on which type of IRA you choose.

The money will then be invested in whichever investment vehicle you choose.

For those who are eligible for employer matches in their 401k. Take it, for sure. Don’t make me get ugly. Next thing to consider is that most employer matches come in the form of company stock, which can be great. Especially if you company performs well.

This investment is considered as a before tax contribution or a Traditional. Later on, this will be something to consider when you are making decisions about rollovers, as well as distributions when you are retired.

Any dividends you receive in your 401k are eligible for reinvestment at no charge. This is an awesome way to grow your savings and I would highly, highly encourage you to take advantage of this option. Remember through all of this compounding is our friend.

Let’s talk about investment choices within a 401k. These ideas apply to either the Traditional or Roth designation.

Within your 401k plan, your employer is going to provide investing options for you. They are going to be a mixture of mutual funds, ETFs, index funds, bonds and target date funds.

So you can choose any mixture of those investments that you want. And you can mix them however you wish. Let’s take a look at them each briefly.

 

  • Mutual funds will be the most common option for you. Within this category, you will typically have choices between large cap, small cap, international, emerging markets and so on. One thing to keep in mind with mutual funds is the fees involved. Typically there are more expensive than ETFs or index funds. This can substantially erode your money.
  • ETFs are similar to mutual funds with one huge difference. The fees are drastically reduced which is great for you. You have the same assets available to invest in but at a lesser cost.
  • Index funds are the lowest fees in the fund class. These funds track a particular index such as the S&P 500. Again you have the same choices of assets to invest in.
  • Bonds are probably the narrowest choices you will have. Typically you will have a bond index fund and maybe an emerging market bond fund or international bond fund. This part of your portfolio should be the thinnest.
  • Target date funds. These are funds that have a target date picked out for you based on when you are scheduled to retire. Each fund then has an allocation strategy picked out for you. As you are younger the allocation will be more aggressive and as you age the fund will shift to more conservative allocations to help protect your investments as you get closer to retirement. This is the best option to start with if you have absolutely no idea what to invest in and want to get started.

A typical asset allocation for your portfolio in a 401k would look something like this.

 

  • Age: Less than 40 — 100% equities. Of this, invest 40% in a large cap growth fund, 25% small cap growth funds, 25% large cap value funds, and 10% International.
  • Age: 40-50 — 80% equities and 20% fixed income. Of the equity portion, invest 40% large cap growth fund, 25% small cap growth funds, 25% large cap value funds, and 10% International. The fixed income would be in bond funds.
  • Age: 51-55 — 70% equities and 30% fixed income. Same allocation as above for equity portion and 30% in bond funds for the fixed income segment.
  • Age: 56-60 — 50 % equities and 50% fixed income. Same allocation as above.
  • Age: 60-65 — Reduce equities 5% each year and increase fixed income 5% each year, so that at retirement you 25% equities and 75% fixed assets.

 

Ok, so we have talked about what a 401k is and how they work. We have also talked about different investments available and asset allocation strategies to help maximize your account.

Some stark differences between the two accounts are first. With a 401k your investment choices are pretty limited. And in some cases limited to expensive mutual funds which are going to drive down your investment gains with all the fees you will be responsible for.

The 401k allows you the option to switch in and out of different investment options, however, you will be charged a fee for these transactions. This can get very expensive very quickly so it is a better idea to at least talk through ideas before implementing them. As you get closer to retirement, saving every penny becomes important. And the choices you make for your retirement account will have a big impact on your ability to make enough money to retire with.

The investment choices with a Roth are limitless. You can literally buy your company’s stock if you want, at any time. This gives you tremendous freedom to design your own retirement portfolio as you wish. You can have stocks, bonds, warrants, muni’s, T-bills, and the list will go on and on. Also remember that this is all done with after tax money so you are not on the hook for any taxes at this point. You also don’t have that pesky RMD that you have to do every year

So why would you choose one over the other? One reason could be because your company doesn’t offer a match at all. In that case, what would be the opportunity to invest in the 401k when you have other, possibly cheaper options that you get to choose for yourself.

So let’s say your company doesn’t offer a match, then what do you do? My suggestion is to max out your Roth IRA first, for the tax benefits. And then you look at putting money into the company’s 401k for the tax benefits. Remember that the contribution limits for a Roth are $5500 for single filers and $6500 for older signers. Once you reach this limitation of the Roth then you can start investing in the 401k  again.

So we have spent some time talking about the 401k and your investment options. Now we are going to take a moment and talk about the Roth.

First, I want to remind you that a Roth is an after-tax retirement account. Meaning that any money you contribute will be after the taxes are deducted from your paycheck. The advantage of this for you is that you are not going to have to pay any taxes on those contributions when you start doing distributions during your retirement.

This can save you thousands of dollars in your retirement. And let’s be honest who doesn’t want to save money on their taxes.

As for your investment options. The door is wide open to anything you want. You can buy individual stocks, bonds, mutual funds, ETFs, index funds, real estate and precious metals. These are all available in a Roth.

The advantage for you if you go down this road is that it gives you so much more flexibility and control over your own finances. If you are of the type where that matters to you, then this is the way to go.

Keep in mind this should be after you determine that you are not going to have any matching funds in your 401k from your employer. If you do have matching funds then you must take advantage of that and then start contributing to the Roth.

Another advantage to the Roth is the ability to keep your fees for your investments down. As we discussed in my post on mutual funds, the fees on those types of investments are a killer. They can cost you thousands over the course of your investment lifetime.

With the flexibility that you have to choose so many more options, you have the ability to keep those fees down even more on other investments as well. For example, instead of two or three different index funds to choose from you would have hundreds. And you could search for the ones that have the lowest fee structure and still fit your investment criteria. A win, win for you.

 

Final Thoughts

 

Investing for your retirement offers some really big challenges. Which account do I choose? Which investments do I choose? How much money do I need to invest?

If your employer offers any type of retirement accounts you should learn as much about them as you can before making your choices. Most employers offer at least a 401k for their employees. This is in their best interests because if they offer a benefit for your retirement it can help promote better employees.

If your employer offers matching funds for your contributions you must absolutely take advantage of that. I mean that is free money, and who likes to give away free money? Nobody.

The best thing for you to do is to contribute as much as your employer matches, to take advantage of that benefit. Then, if you are able, you should open a Roth IRA and contribute as much as you can to that to give yourself some options.

One thing I will mention about investing in your 401k. Each plan offers prospectuses on each investment. This is a document that outlines what each mutual fund offers in regards to investment styles and a listing of the top stocks in their portfolio. They will also list their fees for that particular fund.

This allows you to research all of your potential investments to see which would be the best fit for your allocation strategy, risk profile, and fee structure.

So as you can see this is not about a 401k versus a Roth, but more about how they can work together to give you the best option for your retirement savings. If your employer doesn’t offer the match start with the Roth.

I wanted to mention one final thing about the Roth IRA. There are some opinions that you should only invest a Roth or Traditional, depending on your viewpoint. To me, this is silliness. They both offer some great advantages and you can mix and match them to your advantage.

What do I mean by this? If you are younger, chances you will be making less money at the start of your career. At this stage, it makes absolute sense to contribute to a Roth for the tax advantages. As you age and move up in your career you will, hopefully, be making more money. At this stage, it would make more sense to move to a Traditional to take advantage of those tax benefits.

As you can see there are so many ways that you can arrange things to take advantage of all the different accounts. It’s just a matter of deciding what your plan is going to be and executing on it.

As always, thank you for taking the time to read this and if you found something you think someone would find useful. Please share it with them.

Until next time, take care

Dave

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