Comparing a Roth IRA With a 401k: 5 Basic Points

Originally called Roth IRA Plus, the Roth IRA (Individual Retirement Arrangement) came into being in 1989 as part of the Tax Payer Relief Act of 1997. A cynical view as to why the Government created the Roth IRA is that it was missing out on the deferred taxes that were going into 401k’s (which arrived on the scene in 1980) and wanted a way to keep the tax revenues flowing. The “official” reason is that Senators Packwood (OR) and Roth (DE) envisioned the IRA Plus to be a way for average Americans to save for retirement and to be able to leave something behind for their children.

  1. What are the key differences between a Roth IRA and a 401k?

401ks are employer sponsored and investment choices are limited to what the plan offers. Employers have the option of matching some percentage of employee contributions.  A Roth IRA is set up between an individual and a financial services firm. Therefore there is no opportunity for an employer match. The range of investment choices is not restricted.

Contributions made to a 401k are tax deferred whereas contributions to a Roth IRA are taxed. Withdrawals from 401ks after age 59 ½ (contributions and any money earned on those contributions) are taxed at prevailing income tax rates. Withdrawals from a Roth IRA after age 59 1/2 (contributions and any money earned on those contributions) are not taxed.

The annual contribution limits are higher for 401ks. In 2015, an employee can contribute $18,000 (not including employer match). Plus there is an additional $6,000 that employees over 50 can make. The contribution limit for a Roth IRA and a traditional IRA is $5,500 and the over 50 catch up contribution is $1,000.

In order to qualify for a Roth IRA, single individuals can not earn more than $131,000 (2015) and a married couple $193,000 (who file jointly). There is no such income limit to be eligible to contribute to a 401k.

  1. When can someone begin withdrawing money?

The earliest that you can begin withdrawing your money from a Roth IRA and 401k is 59 ½.  401ks require you to start taking money out by 70 ½ at the latest. These withdrawals are called Required Minimum Distributions.  Roth IRAs have no mandatory withdrawal requirements.

  1. What are some considerations when evaluating a 401k vs. a Roth IRA?
  • The most obvious considerations are what plans are available to you, your age and income.
  • Contributing to a 401k provides known immediate tax benefits.
  • Predicting your tax rate in retirement is difficult. If your retirement tax rate is lower than your working tax rate, then your 401k contributions and earnings will incur lower taxes. If your retirement tax rate is higher, then the advantage may go to the Roth IRA as neither contributions nor earnings will be taxed.
  • The impact of RMDs on other taxable income upon turning 70 ½.
  1. What are the differences in terms of beneficiaries and income tax for heirs?

For married persons, federal law says that the 401k beneficiary is automatically the surviving spouse even if someone else is listed. A different person may be named the beneficiary only if the surviving spouse has consented in writing. For single people, anyone can be named beneficiary. If no beneficiary is named then it defaults to the decedent’s estate.

For a Roth IRA, the beneficiary is whoever is named on the account by the holder.

When it comes to taxes, Roth IRA beneficiaries owe no taxes as long as the account is at least 5 years old. To learn more about Roth IRA tax ramifications, CLICK HERE.

Here are some important considerations for 401k beneficiaries.

When a person dies, their 401k becomes part of their taxable estate. However, a beneficiary generally won’t have to wait until probate is completed to receive the account balance.

A 401k beneficiary will need to pay income tax on the amount received but there are different strategies to spread out or delay the tax burden, especially for spouses.

To read more about these strategies CLICK HERE.

There are other considerations, too (such as estate taxes), so be sure that you always work with a qualified tax expert before making any decisions.

  1. Does it make sense to convert your 401k into a Roth IRA if you are already retired?

There are 2 factors that need to be considered.  First, here’s a simple example to demonstrate the financial implications. Let’s say you have $100,000 in a 401k that you are interested in converting to a Roth IRA. Assume that your current Federal tax rate is 25% and that is what you expect it will be when you begin making withdrawals in 10 years. Assuming an interest rate of 5%/year, that $100,000 will grow to $164,766 in 10 years time. If you withdrew the $100,000 to convert to a Roth IRA, you’d pay $25,000 in taxes leaving $75,000 to grow. Over the same 10 years that $75,000 would be worth $123,574 a difference of -$41,192. If you withdrew the entire $164,766 from your 401k after 10 years it would be worth $123,574 ($164,766 X (1-.25) – the same as if you had done the Roth IRA conversion! However, if the future tax rate was 28%, the 401k would only be worth $118,631, a difference of -$4,942 in favor of the Roth IRA. Of course if the future tax rate was lower than 25%, then the advantage goes to the 401k.

Second, when someone reaches age 70 ½ they have to begin taking distributions from their 401k (Required Minimum Distributions). These RMDs may have negative tax consequences. If the RMDs are substantial enough, they might put you in a higher tax bracket which would affect all of your income. RMDs could also boost your Social Security tax rate. An advantage of a Roth IRA is that the distributions have no affect on your tax rate and therefore no impact on your income tax and Social Security tax.

Some Final Thoughts

  • Roth IRAs are gaining in popularity in the labor market. As long as someone qualifies, a Roth IRA is worth investigating due to its future tax free withdrawals.
  • If you are already retired and only have a 401k, converting to a Roth IRA is a complex matter and should be done in conjunction with professional guidance.
  • Someone who is currently working might want to consider a blended strategy. Let’s say your employer offers a 401k, including a matching contribution, and you also qualify for a Roth IRA. One approach is to contribute enough to your 401k to max out the employers match and then to invest the rest of your savings into a Roth IRA. This approach enables you to reap the benefits of both options.
  • As an early retiree, my strategy has been to take early withdrawals from my 401k, pay the taxes (now at a lower rate since I’ve stopped working) and thereby lower my future RMDs (and their potential future negative tax impact). Please see my earlier post Timing Your 401k Withdrawals.
  • Predicting the future whether it is for rate of return, inflation or tax rates is virtually impossible. I prefer to work in the present where these variables are known. But that’s just my take and not a recommendation.

Note: the information contained in this article is not offered as advice or guidance. Its purpose is illustrative – not instructive or prescriptive. As always, consider seeking professional advice when it comes to your financial decisions.

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