Have a question about money? Send it to me and you could be the next featured reader question. Check out this great one from Julia:
I recently paid off all my debt, now I’m looking to increase my investing beyond my company-sponsored, traditional 401K.
I understand the tax advantage of a Roth – I must’ve read it 50 times while researching this topic.
I don’t understand the difference between 401K and IRA. It looks like the biggest difference is options: 401K is more restricted in how I can invest, whereas IRA has a smaller contribution limit.
It seems like everybody recommends Roth IRA over Roth 401K and I don’t understand why.
Let me add this: I’ve had a traditional 401K for several years and I generally don’t pay any attention to it. I know what I’m contributing; I know that the growth rate has reasonably matched the market in general; and I occasionally get a notice that my allocations have changed, so I guess somebody is managing it. If I’m being perfectly honest, I will never have the interest or patience to learn about investing – my brain doesn’t work that way (seriously, I think I could learn brain surgery faster than I could learn investing). And for that, the idea of picking my own investments intimidates the hell out of me. And if I’m not bothering to pick my own investments, than what difference does it make in how many funds there are to choose from?
So, what exactly is the advantage of an IRA (compared to 401K)?
This can be a very confusing topic and I cover some of it when I explain how to start investing. However, let’s go a little more in depth to fully answer the questions.
Julia has done the right thing by investing in her 401k while paying off her debt so she can start building her nest egg. If you have access to a 401k, you should at least invest enough to receive the match from your employer while paying off debt. You can increase contributions when the debt is gone.
IRA vs 401k
IRA stands for an “individual retirement account” and is basically a retirement account that anyone can open (some income restrictions). All you need to invest in an IRA is an earned income, and you can invest up to $5,000 per year ($6,000 if over age 50). You contribute to an IRA after you pay taxes, but then you can deduct the contribution amount at the end of the year – thus, lowering your tax bill. Basically, you get to invest tax-free but you’ll get hit with taxes when you take it out for retirement.
The 401k is also a retirement account, but you can only open one if your employer offers it. The federal government offers an equivalent account called the Thrift Savings Plan (TSP) and non-profits offer the 403b which are both similar to the 401k. These accounts offer a much higher maximum contribution than the IRA at $17,000 and $22,300 if over the age of 50. Typically, 401k contributions are taken out of your check before you receive any money.
So the first difference between the IRA and 401k is maximum contribution, the second difference is how you fund them, and the third difference is where you invest the money. The IRA allows you a very wide choice of investments – from stocks, ETFs, and mutual funds all the way to real estate and even cattle! However, the 401k only allows you to invest in what the company offers. Typically, your employer will have a fund administrator (such as my favorite, Vanguard) and they’ll work together to determine your investment options.
What’s Roth got to do with it?
Now that we have the differences out of the way, let’s add in a new element – the Roth designation. The “Roth” is basically a tax law named after its chief legislator, Senator William Roth. The Roth designation allows you to invest in an account after taxes, but receive the entire amount of money tax free when you retire!! That means any earnings, dividends and all appreciation will be your’s, tax free! If you haven’t figured it out yet by the number of exclamation points, Roth = awesome.
Roth’s were originally attached to IRAs, giving you a second option for your type of IRA. You can open either account separately, and you can have both open at once. Next, congress attached the Roth designation to 401k’s, allowing you to have the same tax advantage with your company 401k – if your company offers it.
The other huge advantage of a Roth is your ability to take contributions out both tax and penalty free, after a period of five years. Some people will use the Roth IRA as their medium term account for purchases in the 5-10 year range. You can’t do this with a traditional IRA or 401k – you get hit with taxes and typically a 10% penalty.
Just tell me where to put my money
I generally recommend starting with your matched account (401k) and investing enough money to receive your company-sponsored match since it’s basically free money. Most 401k accounts will offer a “name your retirement date” type fund where they’ll automatically adjust the holdings (stocks vs bonds) based on how long you have until retirement. This is a good place to start. If your company offers a Roth 401k, I’d take that over the regular 401k.
After you’ve reached your match, feel free to take your contribution all the way up to 10-15%+ based on how you’re doing financially. If you have more debt, you may want to contribute less so you can pay off debt.
Next, start your Roth IRA and try to get it to the max of $5,000 per year. If you have extra money after that, continue increasing your 401k contributions.
Note 1: Make sure you have your emergency fund (3-6 months expenses) before maxing out your Roth IRA.
Is it really this easy?
Yes and no; there are many different directions to head based on your personal situation. For example, if you think your taxes are higher now than they’ll be in 30 years when you retire, you probably don’t want to do a Roth. However, I don’t know of anyone who thinks that. Also, if you’re a high earner but fall within the contribution limits, there may be some advantages to forgoing the Roth and investing in a 401k so you can lower your adjusted gross income. Either way, study up some more so you’re comfortable with your investment decisions.
The important part is to start investing today so your money can grow on itself. Check out this post to see how long it will take you to reach your first million.