“Contributing to one or the other is a great decision for just about anybody, particularly if your employer offers a match on your contributions.”

Financial Friday: 401k vs. Roth IRA: How Are They Different and Which is Better?

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Welcome to The Wealthy Healthy, the podcast and blog dedicated to inspiring better mental, physical, and financial health. I’m your host, Riki Newton, and today’s Financial Fridays episode is going to be a high level overview of the most common, popular, and accessible retirement and investment vehicles in the traditional 401k and a ROTH IRA. We’ll keep it basic but comprehensive today, exploring their differences, advantages and disadvantages, and so on. In future episodes we will likely take a deeper look at other channels such as ETFs, CDs, peer to peer lending, employee stock purchase programs, and stock market trading, but again for today the focus will be on the basics of a traditional 401k and ROTH IRA or ROTH 401k.

I should also preface that international listeners may not benefit directly from this episode as many of these investment vehicles are specific to the U.S.

That having been said, without a doubt the first and most common channel when people think of saving for retirement has got to be the 401k and Roth IRA, and with good reason. I’ve more than once seen people well into their careers with an open tab on Google inquiring, “what’s the difference between a 401k and a ROTH IRA?” And that’s nobody’s fault really… not only are we generally poorly educated on this in the U.S., but it is also a pretty confusing subject, and it’s easy to forget what’s what if you haven’t really spent some time committing it to memory or reading or discussing the differences with some frequency. Some accounts are pre-tax, some are post-tax, some can be opened on your own and some require an employer… some incur penalties for early withdrawal and others don’t under certain circumstances — so what gives? And which one is right for me?

Let’s start with the traditional 401k. The easiest way to put it is that a traditional 401k is a PRE-tax account generally accessible to you by an employer who provides such a program. What this means is that if you have a $1000 paycheck and you dedicate 15% of your earnings to a 401k, you will receive $850 — the $150 you’re saving goes straight into a 401k, which usually can be allocated either manually to indexes and equities of your choosing, by a robo advisor, or by a rather passive target date fund program. More on that in a few minutes.

So what does it mean that it’s pre-tax? The money grows in an account tax-deferred, or in other words you defer the responsibility of paying taxes until the future. When you begin withdrawals, the money will then be taxed.

Some advantages of the traditional 401k are that your current taxable income is what’s left over. So for example if you have a $100,000 a year salary before taxes, and you’re under 59 and a half, and you max out your 401k or come very close, you can only be taxed on about $82,000 of that income. For the record, the annual maximums for those under the age of 59 and a half is $18,000 annually and for those over 50 is $24,000 annually as a catch up system. Let me repeat the earlier point: for that calendar year you will only be taxed on the remainder of your income. This can be an incredible advantage to anyone but that becomes particularly true if you’re someone who can enter a lower tax bracket by saving into a 401k.

As a made up example, if you earn $50,000 a year salary and your state and federal taxes make you accountable for paying up 30% of that to Uncle Sam, you owe $15,000 in taxes. However, let’s say that in your state, people earning $40,000 a year will instead be taxed 25%, meaning they owe $10,000 in taxes that year. If you dedicate 20% of your $50,000 a year salary to a 401k, you take home $40k before taxes, but now you’re only responsible for $10,000 in taxes instead of $15,000. So, your take-home pay at the $50K level when dedicating nothing to a 401k would be $35,000. In the latter example of investing 20%, your take-home pay is $30,000, BUT you’ve invested $10,000 in an account that is all yours. So your net worth is actually higher as long as you aren’t taxed at 50% or more upon future withdrawal from the 401k, which is not impossible if political or financial chaos strikes the U.S., but that much is very highly unlikely. And not only that, but your $10,000 will actually accrue interest over time – if you had that $10,000 now, odds are you’d either spend it on depreciating liabilities, or you’d be watching it rot in a bank account failing to outpace inflation. One considerable disadvantage of the 401k is that it’s quite illiquid, so if you have yet to build up an easily accessible emergency fund of 3-6 months worth of expenses, I highly recommend prioritizing that before building your 401k portfolio.

Now, I mentioned a moment ago that your 401k accrues interest, and as we all probably know, interest of this sort compounds. There is some specific math and decades upon decades of market trends to come to rules of thumb on what you can expect in terms of interest, but the simplest baseline is that every 10 years, appropriately allocated investments will approximately double in value. Of course, this doesn’t consider some inflation and the eventual taxes, but you can imagine how powerful this can become over time. If in your first year out of school at 22 years old you sock away $10,000 and never invest in that account again, by retirement 4 decades later, that account should be worth somewhere in the realm of $160,00 — $10,000 becomes 20, 20 becomes 40, 40 becomes 80, 80 becomes 160. So while the buying power of $160,000 in 2057 will be less than it is today, and though you’re still on the hook for taxes, you can imagine how completely out of control inflation and taxes would have to be for you to not walk away with much more than you started with. By contrast, leaving that $10,000 in a checking account for 40 years will probably leave you with the equivalent of somewhere in the realm of $6,000 or so in today’s money. Disclaimer here, I didn’t even bother with the exact inflation math, just illustrating the point which I think comes across clearly.

There’s actually another point to consider too. Many employers, particularly if you work for a public company, offer a 401k match, meaning your employer will actually hand you extra free money just for contributing to a 401k. Sound too good to be true? It isn’t. It’s actually that simple. Free. Money. Every employer will have a different program, so be sure to do a little digging or ask good questions during your orientation when you start a new job – ideally you ask for this information prior to signing any offer letters. Some will be incredibly generous and offer a no-strings, no-frills match of some fixed percentage of your contributions, so for example is your employer offers to match 10% of all 401k contributions and you invest $10,000, they’ll throw a free $1,000 on top. More commonly there’s some confusing terms, but nothing where you’ll be screwed over; free money is free money.

Common arrangements include systems like offering a 50% match on only the first $3,000 contributed, or multi-year program with a one-year cliff where you own none of your employer contribution amount until you’ve been there a year, at which point you claim something like a quarter of the total, and thereafter you gain ownership of more and more of that account each month or year. Again, each is different, but if your employer offers basically any type of match, it’s all the more reason to contribute at least something in the spirit of never leaving free money on the table.

Now, in the past there was much contention over whether a 401k is right for a potential early retiree, but the book has been written and closed on this: not only do you still net out better in the end under nearly all realistic circumstances, but there are a handful of ways to access those accounts early at little or no penalty, most popular among them being the 72(t). I will undoubtedly cover that sometime in the future but if you must know now, a quick Google search can help provide some color.

Next let’s talk about a ROTH IRA and then we’ll go over some basics of how allocations within these accounts work, and wrap up our discussion today with a conclusion on whether one account type is better than the other – the answer might surprise you!

A ROTH IRA or ROTH 401k is a POST-tax account with some similarities to a traditional 401k. We won’t talk today about nitty gritty things like taking out a loan from yourself for first home purchases or emergencies, or the penalties for early withdrawal, or rollover IRAs, but in the spirit of staying fairly basic and high level let’s discuss quick similarities and differences. Like a traditional 401k, a ROTH account is fairly illiquid, and withdrawal can begin without penalty at the same designated retirement age. By contrast, all IRAs you own whether employer or personally set up with someone like a Fidelity or Vanguard have an annual cap of $5,500 annually, or for those over 50, $6,500 annually. A notable difference is that ROTH accounts, again, are post-tax — this is why you can set one up without an employer, as odds are quite high that money you have in your hand or in a bank account has already been taxed by the time it’s under your command. A post-tax account means that the money you put in has already been taxed, but when you begin withdrawal, you will NOT be taxed again. Your tax rate in the future doesn’t influence how much of the money is yours; it’s ALL yours. What you see is what you get. If your ROTH account has $300,000 in it at your retirement age, you own all of it. No taxes, regardless of what your tax rate was 30 years ago or what it was in your last job before retirement or your earnings from whatever work you may be doing after retiring from full time work.

This is where the major contention starts, and I’ll get into it more in a minute here, but some people believe politics will drive taxes up or down, some believe they will make or need more in retirement than they make or need today – especially if you’re on the younger side – and that a higher or lower future tax rate makes one account type superior to another. Again, we’ll blow the lid on this soon. First, let’s talk allocations: where the heck is the money in retirement accounts actually sitting, and how can we ensure we’ve picked the right investment strategy to maximize potential growth of those accounts?

I mentioned before that there are a few places this money can be invested and a few ways to invest it. If you’re knowledgeable or interested in becoming knowledgeable, and you want to take control of your allocations within your accounts, you will need to dig and compare and read and ask. I highly recommend asking for help from a certified financial planner or a friend who really knows his or her stuff who perhaps works in finance, hedge funds, etc. – I personally went both routes and when their advice matched up, and their advice came pretty close to my own thoughts, I felt confident that I made the right decisions for my age and risk tolerance. Recognize some basics: going 100% into US stock indexes might lack diversification and carry too much risk, and the younger you are and the more time you have the more aggressive you might consider being.

Alternatively you can take advantage of a robo advisor or a real advisor. This can reasonably be considered semi-involved, as you’ll help drive decisions but someone or something else is telling you what makes pretty good sense given your age, timeline, risk tolerance, etc.

And lastly, or at least lastly for the purposes of this episode, are target date funds. These can reasonably be considered totally passive: essentially you tell the program that you want to retire in 2055 and it’ll automatically make decisions for you based on how close or far you are from that intended date: the further away, the more aggressive and stock-heavy the allocations, and as the closer you are to your target retirement date, the less aggressive and lower-risk the allocations, switching focus to bonds and other low-yield but high-stability choices.

So, which choice is better, and who does it matter for? Well, most things held equal, the better choice is….. either! I won’t go over the math here because it’s already been done and explained far better than I ever could: Joshua Sheats of the Radical Personal Finance episode breaks down the math in episode 303 of his podcast, one of my favorite all-time episodes of his often excellent show. I highly recommend you find and download that particular episode as he actually does the math to prove a former assumption of his wrong. There are, of course, some things to consider when you are targeting a very early retirement, such as the potential for you in the future to actually be in a much lower tax bracket. However, for most, it can be assumed that you will progressively make more throughout your career – based on this and other simple assumptions like figuring taxes will not be outrageously different in the future, Joshua Sheats does a great job going through what can reasonably be held equal and what you walk away with in retirement by investing identical sums into pre and post tax retirement options. Great listen if you want the details but the spoiler conclusion is, it doesn’t matter. One is assuredly not better than the other, and you are in putting yourself in an amazing position if you are able to max out both resources. If you aren’t, the gut reaction is to lean traditional to enjoy the decreased tax now, but at the same time, being unable to max both might suggest that you are in a low-to-moderate earning situation, in which case your future earnings and future tax bracket may be considerably higher — but again, don’t overthink this too much. Chances are incredibly high that $5,000 placed into either type of account will net out to the same available income in retirement. Contributing to one or the other is a great decision for just about anybody, particularly if your employer offers a match on your contributions.

Alright everyone, thanks for tuning in, as always feel free to share your thoughts, your praise, your criticism, it all serves to make the show better.
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