NEW YORK (CNN/Money.com) -
Should I increase my contribution to my 401(k) plan, where I invest pre-tax dollars, but eventually pay taxes on withdrawals? Or am I better off putting the money in a Roth IRA, which provides no immediate tax benefit but allows me to withdraw my money in retirement tax free? Is there a rule of thumb for making this decision?
-- Justin Matuszek, Racine, Wisconsin
Actually, there are a couple of rules of thumb that apply to the 401(k) vs. Roth IRA question. Keep in mind, though, that you've always got to be careful when relying on a rule of thumb because you just might end up breaking a few fingers. (I don't know what that means, but it sounds kind of clever and profound, so I'm going with it.)
Get the free money
The first rule of thumb is that you should always invest at least enough to take full advantage of any 401(k) matching contribution your company offers. After all, a match is about the closest thing most of us ever get to free money.
Here's the second rule of thumb: If you expect to be in a lower tax bracket in retirement than you are during your career, then you're generally better off continuing with the 401(k).
If you think you'll be in a higher one, then the Roth is usually the better deal. If your company plan doesn't offer matching contributions, then forget rule of thumb number one and go immediately to rule of thumb number two.
Let's look at an example. Say you're in the 30 percent combined federal and state tax bracket and you've contributed enough to get your employers' full match and you have another $3,000 that you could funnel into your 401(k) or into a Roth. Now, let's say that regardless of which you choose, you expect to earn 10 percent per year on your investment and that you plan to withdraw the money after 10 years. (Let's further assume, for simplicity's sake, that you face no premature withdrawal penalties when you pull the money out.)
Let's see what happens if you choose the Roth IRA. First of all, unlike money you put into a 401(k), you've got to pay taxes on a Roth contribution. So we deduct 30 percent from $3,000 to give you a net investment of $2,100. Assuming that $2,100 earns 10 percent per year, in 10 years your investment would be worth $5,447. Since you face no taxes on the Roth withdrawal, you can pull the money out and pocket $5,447.
Now, let's move to the 401(k) option. Here, you get to invest the full $3,000, which means at a 10 percent annualized rate, your original investment would grow to $7,781. But you've got to pay tax on the withdrawal, so the tax rate you pay at the time of the withdrawal also enters the equation. If your rate remains the same at 30 percent, then you would pay $2,334 in taxes, leaving you with $5,447 -- the same as in the Roth.
If you fall to, say, a 25 percent combined rate, however, your tax bill would drop to $1,945, leaving you with $5,836 in the 401(k) -- more than with the Roth. On the other hand, if your rate rose, say, to a combined 32 percent federal and state rate, your tax bill would increase to $2,490, leaving you with a net $5,291, or less than with the Roth.
Rules of thumb can be rendered inaccurate by unforeseeable events, however. Do you really know what tax bracket you'll be in at retirement? If you save diligently and your investments earn big returns, you might be able to withdraw enough to drive you into a higher tax bracket. If you don't save and your returns fare poorly, you might slip into a lower one. There's also the wild card of where Congress will set tax rates in the future. Talk about your imponderables.
Beyond that, there are other considerations beyond taxes that come into play. A Roth may be more appealing because it's easier to get at money in a Roth than in a 401(k). For example, you can withdraw your own contributions from a Roth without paying any penalty. (Things can get trickier when you're dealing with Roth rollovers and with the earnings in the account. For an in-depth look at the tax treatment of Roth withdrawals as well as eligibility requirements for Roths, click here.)
And while you've eventually got to begin drawing money out of your 401(k), you aren't required to do so with a Roth. So if you want to leave your heirs a big pot of money, you may want to opt for a Roth.