How to Choose Between a 401(k) and a Roth IRA

Here’s how to select the best tax-favored retirement account for your nest egg.

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Retirement savers must decide whether to invest in a 401(k) or Roth IRA. If a 401(k) plan offers a company match, then an investor should definitely take advantage of it. But once you get the maximum possible match (or if your company doesn’t offer one) you must choose whether to allocate additional savings to a 401(k) or Roth IRA. The main difference between the two accounts is how your contributions are taxed. Here’s how to decide which tax treatment is right for you.

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Roth IRA. I love the Roth IRA plan because once I contribute after-tax dollars I never have to pay tax on that investment ever again. In 2012, an investor can contribute up to $5,000 of their after-tax savings, or $6,000 if age 50 or older. A Roth IRA also has fewer withdrawal restrictions than a 401(k). If an investor withdraws money from a Roth IRA before age 59½ he or she will incur an early withdrawal penalty and regular income tax only on the portion of the withdrawal that comes from earnings. There are also several ways to avoid the early withdrawal penalty, such as when you use the money to purchase a first home or for college costs.

401(k). If an investor is currently in a high income tax bracket, then it is probably more advantageous to invest in the 401(k) than the Roth IRA. When you retire, your tax rate will most likely be lower than what it was when you were working. Your earned income will drop and you will pay significantly less tax and perhaps even move down to a lower tax bracket. If this is true for you, then it is better to defer tax payments until you start withdrawing from the retirement fund by investing in a 401(k). You can also defer taxes on more money in a 401(k) than in an IRA. There is a $17,000 annual limit on 401(k) contributions for 2012, compared to $5,000 for a Roth IRA. People age 50 and over can also contribute an additional $5,500 above this annual limit, versus an extra $1,000 in a Roth IRA.

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Invest in both if possible. It is best to max out both a 401(k) and Roth IRA if you can. Having some assets in both types of accounts adds tax diversification to your retirement portfolio. This gives you the flexibility to avoid going into a higher tax bracket when you are retired. If your income from 401(k) withdrawals and other sources is about to push you into a higher tax bracket, then you can reduce your 401(k) withdrawal rate and take money from your Roth IRA instead, which is generally not taxed in retirement.

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It depends on your tax rate. If you can only invest in a Roth IRA or 401(k), first take full advantage of any 401(k) match offered. Then consider how your current tax rate compares to your expected tax rate in retirement. I expect my retirement income to be much less than my current income, so I enjoy taking a tax break now by investing in a 401(k) first. If I was in a low tax bracket now, I would consider investing in the Roth IRA first. However, it is impossible to predict future tax rates, so it is best to invest in both a 401(k) and a Roth IRA to receive both tax breaks.

Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.