Roth IRAs vs. 401(k)s

NEW YORK (Money) -- Question: I'm 25 and recently switched employers. Although my new company provides a lucrative profit-sharing plan that everyone is automatically enrolled in after one year of work, my new employer does not offer a match in the 401(k). I can budget approximately 20 percent of my income for retirement savings, but I'm confused about how to allocate those savings.

Should I max out my Roth IRA and then put what's left in the 401(k)? Should I put 10 percent of income in each? Or is there something else I should be thinking about? - Scott H., Denver, Colo.

Answer: First, let me say that in the grand scheme of things, the most important decision for a person in your position isn't how you divvy up your savings between your 401(k), Roth IRA and any other options. It's that you start saving and investing on a regular basis. The fact that you've decided at the tender age of 25 to sock away 20 percent of your income shows that you've aced this first test.

No matter how you allocate your savings, you're going to do just fine as long as you keep socking away a good portion of your paycheck.

That's not to say that the issue of where to put your savings isn't important. It is. But unless you have a crystal ball that tells you what tax rate you'll face in the future, there's no way to know for sure in advance what the optimum mix is anyway.

That said, however, given what you've told me and assuming that you're a 25-year-old with good career prospects ahead of you, I'd say you should probably first make sure you max out the Roth - which means investing up to $4,000 in 2007 and $5,000 next year, after which the maximum increases in $500 increments depending on inflation - and then stick whatever else you can into your 401(k).

If you hit the limit on your 401(k) and still haven't put away 20 percent of your income at this point - or if you can afford to set aside more - you can move on to tax-efficient investments like index funds and tax-managed funds. (For more on those options, click here.)

So how do I arrive at the suggestion that you do the Roth first and then the 401(k)? Well, to understand why, you need to know a bit about the differences between the way a 401(k) and Roth IRA work, and the implications of those differences.

With a 401(k), you invest pre-tax dollars and pay tax on your contribution and all earnings when you withdraw the money from your account, preferably in retirement. That means you escape taxes today, but pay them tomorrow.

When you do a Roth IRA, by contrast, you're investing after-tax dollars today and paying no tax on the withdrawals (assuming you meet the various requirements for tax-free withdrawals, which you can check out by clicking here). So with a Roth, you're paying taxes today and escaping them tomorrow.

This means that, generally, a 401(k) is a better deal than the Roth IRA if you think you'll face a lower tax rate in retirement than the rate you face during your career. The opposite is true for the Roth.

Note that I said "generally." For one thing, if you're willing to contribute the max, the Roth effectively allows you to shelter more money from taxes than the same sum invested in a tax-deferred account, which gives it a bit of an advantage all other things being equal. (The explanation for this advantage is too long and boring to go into right now, but if you want more details about it, click here.)

The availability of employer matching funds can make a 401(k) the better deal, even if you expect to be in a higher tax bracket in the future. Your 401(k) doesn't have a match, but most do, which is why I typically tell people to first contribute enough to their 401(k) plan to get the maximum match and then consider a Roth.

Another complication is that it can be difficult, if not impossible, to tell whether you'll be in a higher or lower tax bracket in retirement. I would expect that a 25-year-old like yourself just embarking on his career would start out in a relatively low tax bracket and move up to higher tax brackets later on, perhaps even ending up in a higher tax bracket in retirement than the one you're in today.

And, indeed, I think young people whose incomes are likely to rise and push them into higher tax brackets are generally better candidates for a Roth than middle-aged or older people who are in or near their peak earning years and who may later slide into a lower tax bracket.

Given all the uncertainty, I recommend that people of virtually all ages adopt a strategy that I call "tax diversification."

As a practical matter, that means saving for retirement in a way that gives you several pots of money that receive different tax treatment. So, for example, the money you contribute to your 401(k) will eventually be taxed at ordinary income rates in the future. The money you put into a Roth won't be taxed at all.

To the extent you have money left over after maxing out 401(k)s and Roths, I think it's also a good idea to invest in vehicles (such as index funds and tax-managed funds mentioned above) that generate long-term capital gains that are taxed at long-term capital gains rates, which currently max out at 15 percent versus 35 percent for ordinary income rates.

By following this strategy, you'll hedge your tax exposure in retirement.

You won't avoid taxes altogether. Even your Roth money has already been taxed. But by arranging things in advance so that all your retirement money isn't taxed the same way, you'll have given yourself some flexibility and maneuvering room for managing your tax bill in retirement. (For more on how this strategy works and how to adopt it, click here.)

If you think this strategy makes sense - as I do - then it's just a matter of how to carry it out. If you've got a 401(k) that offers a match, then the first thing you want to do is contribute enough to get the full match. After all, why give up free money?

Once you've done that, you can move on to a Roth. If you still have money left, then continue to contribute to the 401(k) until you max out that account. After all, why give up the tax break?

And if you've still got money to save, move on to index funds and tax-managed funds.

The only thing I'm suggesting that you do differently is that you begin with the Roth since you're not getting a match in the 401(k). Assuming you're willing to save 20 percent of your income and that you're making more than $20,000, you'll still money left over after contributing $4,000 to a Roth IRA this year that you can plow into your 401(k) and take advantage of the upfront tax break there.

So go ahead and fund that Roth and then move on the 401(k) and, if possible, index funds and tax-managed accounts. But, remember, the ultimate success of your retirement plan hinges not on finding the optimal mix of different types of accounts, but in remaining diligent in your resolve to save a nice hefty chunk of your income year after year after year.

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