Roth 401(k) vs. Roth IRA (A Guide for the Perplexed)

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Money QuestionsQ: I make approximately $65,000 and my goal is to save 12% of my salary towards retirement. I have a Roth 401(k) option at work (4% match if I contribute 5%) and I also have a personal Roth IRA. Which accounts should I be funding?


Building a Nest Egg

$ ?s answered by Matthew Illian, CFP®


Dear Building a Nest Egg,

Your savings goals are admirable! Make sure you get any free or matching money, and then focus on tax efficiency.

Before you focus on retirement savings, I always like to make sure an emergency reserve account is funded. We all know people who have unexpectedly lost their jobs. I recommend you have three to six months of living expenses in an liquid account.

You are generally a good candidate for a Roth if you can answer yes to any of the following:

  • You’re young and earning less than you will be in the future
  • You’re a “super-saver” and will have a large nest egg in retirement
  • After reviewing the U.S. government’s debts and deficits, you expect tax rates will have to rise in the future and you are willing to pay now for tax free income in the future

You are fortunate to have a Roth 401(k) option. The Roth 401(k) allows participants to pay taxes on their retirement savings contributions up front and avoid future taxes on their plan savings in retirement. All withdrawals of Roth savings are free from federal income tax in retirement as long as the participant is at least 59½ years old and their account has been open for at least five years.

If your employer offers a 401(k) match, start your savings here. At minimum, many employers match the first 3% of your savings. This is free money that you can’t afford to pass up.

For those that qualify, typically the next best place to begin is by adding $5,000 in a Roth IRA. Income phaseouts for Roths begin at $110,000 (modified adjusted gross income, or MAGI) for single filers and $173,000 (MAGI) for joint filers. If you haven’t already funded your Roth IRA for 2011, you still have time to fund $5,000 for last year and $5,000 for this year.

A Roth provides more flexibility than its Roth 401(k) counterpart because you can access the principal at any time without penalty. There are other beneficial provisions for first time home purchases and college expense as well. The point is that investors will prefer the more flexible option when given knowledge about the differences.

Additionally, 401(k) plans must pay accountants to review their plan and trustee fees to custody assets. As you might expect, 401(k)s typically cost 1% in higher fees so you’re better off sticking your extra savings in a Roth IRA with a discount broker like Charles Schwab.

In either case, both plans allow you to stick this money where it will never be taxed again.  Traditional IRAs and 401(k)s will be taxed when you take the money out. And with the income tax debate currently controlled by legislators advocating even higher rates, I don’t think you will regret having tax free savings.

Following these steps and investing wisely will ensure your retirement egg stays golden.

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Matthew Illian was a Wealth Manager at Marotta Wealth Management from 2007 to 2016. He specialized in small business consulting, college planning, and retirement plans.