Ever since Congress created the Roth IRA as part of the Taxpayer Relief Act of 1997, people have been wondering about the benefits of their IRA 401k versus a Roth IRA. Somehow everyone thinks they have to choose between the two, but this is not really the right mindset. As with any other investment, diversification is the key and most people should use both retirement vehicles. As we take a closer look at the 401k vs Roth IRA debate, keep in mind that this discussion applies to the self-directed 401k as well.
The generally accepted wisdom is to contribute to your 401k up to your employer’s match and then max out your Roth IRA. If you still have investment dollars after this, you can go back to your 401k and max it out as well. However, many people wonder if that’s the best course of action, especially for those with a self-directed 401k who don’t have the benefit of an employer match.
Choosing between a 401k or a Roth IRA
Since there are rarely any set rules when it comes to your personal finances, the choice of 401k vs Roth IRA basically comes down to your current income and tax bracket and what you anticipate your income and tax bracket will be when you retire. This makes it easy to make some generalizations, but since none of us have a crystal ball, it’s impossible to say for sure which course is the best.
In general we can assume that a prudent saver and investor will have a higher income when they retire than they do now, especially if we are talking about someone between 20 and 30 years old. This suggests that the Roth IRA will be the best retirement vehicle. We can also look at current income and infer that if he’s in the 25% or higher tax bracket, he now stands to benefit more from using his 401k tax-deferred. However, we have no idea what taxes will do in the future, so we can’t say for sure whether it’s better to have taxable or non-taxable income 20, 30, or 40 years from now.
Diversify and hedge your risk
Since there is no way to determine how tax rates will behave in the coming years, it makes more sense to diversify and use both retirement vehicles (as well as taxable accounts) to save for retirement. When you consider how long people are expected to live, you may be in retirement for 30 years or more, and taxes can change dramatically even in retirement. Consider a scenario where taxes are high when you withdraw, but fall over the next few decades. This means that when you first retire, you’re better off drawing from a Roth IRA, but as taxes come down, you can switch to withdrawing from your 401k, either partially or fully.
As you can see, it may be worth branching out when considering the 401k vs Roth IRA debate. This is true even for those with a self-directed 401k who don’t get the benefit of a company match. In the end, the question isn’t so much which retirement vehicle you use, but whether you’re saving adequately for retirement and allowing yourself financial flexibility.
