For many investors, a Roth IRA is a better investment than contributing to your employer’s 401(k) retirement plan. A Roth IRA is cut from much of the same cloth as a 401(k) retirement plan, but there are several characteristics that make a Roth IRA a better investment option for many Americans.
While this is obviously not true in all circumstances, the tax advantages of a Roth IRA often make it a superlative investment vehicle to help you accomplish your financial goals for retirement.
A Roth IRA Is More Tax Efficient
The largest benefit of a Roth IRA is its tax-free withdrawal of earnings in retirement. To understand this, you need to know the distinction between contributions and earnings.
Investors contribute after-tax dollars from their paycheck to their Roth IRA accounts. Because that money has already been taxed, you can withdraw your contributions at any time without owing tax on them.
Earnings are what those contributions make from your Roth IRA investments. If you withdraw the account’s earnings after reaching age 59½ (assuming the account is at least five years old), the earnings are tax free. These tax-free withdrawals are one of the biggest benefits of a Roth IRA compared to a 401(k) retirement plan.
Inherent in these benefits is a question of timing: Many investors are in a lower tax bracket while they are starting their career. Ultimately they should be in a much higher income tax bracket later in their lives when they are ready to retire. Roth IRA investors pay their taxes early in the investing process and then pay no tax at all on their earnings.
Conversely, 401(k) retirement plan investors reduce their taxable income by getting a deduction when they make each annual contribution. However, when funds are withdrawn late in their careers or at retirement, 401(k) investors pay taxes on both their contributions and all the money they earned in the account.
A Roth IRA Is More Flexible
A Roth IRA allows investors more flexibility than a 401(k) retirement plan. Both types of accounts make wide use of mutual funds. But 401(k) investors are limited to the funds their employers have suggested. Roth IRA investors also have the ability to designate their investment as a self-directed Roth IRA, which opens a much wider choice of investment opportunities including gold and real estate.
A 401(k) retirement plan with your employer often limits an employee’s investment choices to a select few mutual funds and investment options. For example, the federal Thrift Savings Plan, which is the government’s equivalent to a 401(k) retirement plan, offers only five index fund options (plus Lifecyle target-date funds created from these options) for investors to choose among.
Also while you can take out a loan against most 401(k) retirement plans, you are severely penalized if you withdraw your investment from a 401(k) before you reach age 59½.
A Roth IRA provides several opportunities to take an early withdrawal of your earnings without penalties to pay for qualified exceptions such as a home purchase and educational expenses, if you become severely disabled, or other specific instances. In addition—because you already paid taxes on it—you can always withdraw the amount you contributed, at any age.
But: If You Get 401(k) Matching Funds
There’s one big exception to the benefits advantage of a Roth IRA: If your employer offers a matching contribution, you should first invest enough money to get the maximum match. Many employers match up to 5% of an employee’s investment contribution, which is essentially a 100% rate of return on that money. Never ignore free money.
Once you’ve met the match, consider investing up to the IRA contribution limit in a Roth IRA, if you qualify for one.
And that’s the other key “but”: There is an income limit on who can invest in a Roth IRA. For 2019, if you are married filing joint tax returns and earn $203,000 or more per year, you do not qualify to invest in a Roth IRA. For singles, the figure is $137,000. (For 2018, the limits are $199,000 for married filing jointly and $135,000 for singles.)
Know Your [Contribution] Limits
You can’t, of course, invest an infinite amount of money in either retirement-savings vehicle. Note that the IRA contribution limit for 2019 was increased to $6,000 ($7,000, if you’re age 50 and over). For 2018, the limit is $5,500 ($6,500 with the catch-up), and you can contribute for the 2018 tax year through April 15, 2019.
The 401(k) contribution limit also rose to $19,000 for 2019 ($25,000 with the 50+ catch-up contribution) in 2019. For 2018, the limit is $18,500 ($24,500).
If you can manage it, consider investing in your 401(k) up to the matching limit, then in a Roth to the contribution limit. Any leftover funds could go to increase your 401(k) to its contribution limit.
In many cases, a Roth IRA is a superior investment to a 401(k) retirement plan. A Roth IRA offers investors a flexible investment vehicle to save for retirement, while also minimizing the taxes that will ultimately have to be paid. While a Roth IRA is not available to all investors and exceptions can apply, a Roth IRA is often a better investment than a 401(k).