As you know, we’re pretty high on the Roth IRA here at RothIRA.com: We deem it one of the best retirement account options available in the United States. However, as much as we would like to recommend you dedicate absolutely 100% of your investment mix to it, even we admit it may not be the best option for everyone. You might be unable to fully fund an account due to the income limits. Or there might be a good chance that tax rates or your tax bracket will be substantially lower in the future, when you retire, which means you’ll lose money and will have paid Uncle Sam more than you had to by contributing after-tax dollars now to the Roth now. So let’s look at some alternatives to Roth IRAs: 401(k)s and Roth 401(k)s.
Roth IRAs vs 401(k)s
One of the great things about a Roth IRA is that it’s completely customizable. You get to select your investments, or more likely, choose a financial firm to provide investment options (generally, mutual funds). You can target a low-cost provider that offers funds with minimal fees and expense ratios.
In contrast, with a 401(k) offered through your employer, you’re given a choice from a set mix of mutual funds, which tend to be rather expensive, carrying above-average fees and charges. These investment options are selected by a benefits administrator, and are easily influenced by the 401(k) advising firm, which is often is the very mutual funds company that’s providing the investments! The worst-case scenario: All the mutual fund options in the plan have expense ratios above the national average. Instead of paying 0.20% in expenses on your assets (the bare-bones rate), you’re paying 1.25%. Over the years, that extra 1% and change can have a dramatic impact on the overall return of your retirement fund.
As we said, this is the worst-case scenario. Even the lamest 401(k) plan usually has a large index fund option that carries a lower fee, as passively managed equity funds tend to do, and a money market or bond fund option.
Advantage 401(k): the Match
This is why your 401(k) match is so important. Many – though not all – employers offering these plans match each employee’s contributions; a certain percentage of every dollar invested, up to a capped amount. For example, your employer may match of your contributions at a rate of 50%, up to 6% of your salary. So you make $50,000 per year, you invest $3,000 per year (6%) and the company contributes an additional $1,500 (50% of that 6%) into your account. Read that again. The company will give you free money just for contributing to your future. In effect, you’re generating an automatic 50% return on those contributions.
So, which is better? Well, if you get any kind of significant matching at your 401(k), you should fund that first. Never paying taxes in the future with a Roth is great, but earning a huge return (50%-100%) up front on your investment can’t be beat. After you’ve funded a 401(k) to the max match, then look into establishing a Roth.
It is the best of both worlds. You get the convenience of a workplace-sponsored retirement account (hello, automatic paycheck deposits) and other advantages (like the company matching your contributions). You get the option to grow your nest egg and never pay taxes on the total ever again. It is a true thing of beauty. Let’s take a deeper look.
A Growing Trend
Roth 401(k)s are increasingly becoming an option across the country. About 30% of medium-to-large businesses offer one, alongside the traditional 401(k), as part of their employee benefit packages – though fewer than 25% of people offered a Roth 401(k) utilize it.
The main distinction between traditional and Roth 401(k)s parallels that between traditional and Roth IRAs: namely, when you pay taxes. With the traditional, you get a tax break today on the money you contribute to the account – it comes off the top of your gross earnings – and you pay taxes when you start taking distributions from it (presumably after you retire). The Roth version is funded with after-tax dollars from your paycheck; no tax break when you contribute. On the other hand, no tax bill when you start withdrawing funds, either.
Can I Have a Roth and Traditional 401(k) at the Same Time?
Yes, and in fact you have to, if your employer matches your contributions. When your company offers a 401(k) match, the matching funds are put into your account (normally once per year) as tax-deferred dollars. The company gets a tax deduction for employee compensation, and the money that is matched is not taxed until you begin withdrawing it.
However, with Roth 401(k)s, the only problem is those matching funds cannot be after-tax dollars. If they were, it would mean either you or your employer would have to pay taxes on the matched amounts when they were deposited in your account (normally once per year). Your employer probably wouldn’t want to, and nor might you, since it could be a huge hit to your finances. So what happens is, the matching funds are placed into your regular 401(k), as pre-tax dollars. They are then treated as any contribution: They grow tax-deferred and are taxed upon withdrawal.
Roth 401(k) Contribution Rules
The rules for Roth 401(k)s are parallel IRA rules. With IRAs you cannot contribute more than $5,500 per year (or $6,500 per year if you are over age 50) collectively to all accounts, both traditional and Roth. Similarly, the current 401(k) rules stipulate you can contribute up to $18,000 per year for both types of 401(k)s combined. In other words, you could invest $9,000 in both a Roth and Traditional 401(k), but you can’t put $18,000 in each.