Why a 401(k) Trumps Roth IRA Contributions

Your 401(k) can be a better place to invest than a Roth IRA.


Many workers have the option to save for retirement in both a 401(k) and a Roth IRA. If you are unable to max out both accounts, you need to decide which type of account provides you with more value. While most experts will advise individuals to contribute to a 401(k) first until you capture the full employer match, opinions differ for contributions after the match is reached.

I think workers should continue to invest in their 401(k) plan as long as the fund options aren't terrible. Here are a few of the little-known advantages of investing in your 401(k) plan instead of a Roth IRA:

Earlier penalty-free withdrawal age. One of the advantages of a Roth IRA is that you can withdraw your contributions, but not the earnings, penalty-free before age 59½. However, there are also ways to avoid the 401(k) early withdrawal penalty. For example, an employee who retires, quits, or is laid off at age 55 or older can withdraw money from their 401(k), including the earnings, without incurring the 10 percent penalty, compared to age 59½ for IRA withdrawals. Many 401(k)s, but not IRAs, also allow you to take loans from the account before retirement.

Another way to avoid the early withdrawal penalty is to set up section 72(t) distributions. This rule allows you to withdraw a calculated substantially equal periodic payment based on your life expectancy at any age. Don't take this option lightly, though, because you must continue the annual withdrawals for at least five years or until you reach 59½, whichever is longer. However, the option is there for people who need to take money out early.

You can convert to a Roth at any time. If your employer allows it, you can choose to convert money in pre-tax accounts to a Roth at any time. If you wait until a year when your marginal tax rate is lower than it is now, such as in a year you don’t work for the full year or have an unusually low income, you can convert some or all of your pre-tax contributions to after-tax ones without paying as much tax.

Some 401(k)s don’t allow you to convert to a Roth, but there is a workaround. The next time you switch jobs you can roll your 401(k) over to a traditional IRA, which takes away the conversion restriction. Some 401(k) plans also offer in-service distributions, which allows you to move money from your 401(k) to an IRA while you are still working for the same employer.

Tax brackets are inflation indexed. Roth IRAs allow you to pre-pay your income tax at current rates. However, tax brackets are inflation indexed, which means that you will need a much higher income in the future to be in the same tax bracket. Let's say you are in the 25 percent tax bracket right now. In order to be in the same 25 percent tax bracket 30 years from now, your income may have to double due to inflation. By using a Roth IRA you could pay a higher tax rate now than you would if you waited until you drop into a lower tax bracket in retirement due to your lower income and higher tax bracket cutoffs.

401(k)s have more protections than your typical IRA. Under the federal Employee Retirement Income Security Act (ERISA), the assets in a 401(k) are generally beyond the reach of creditors or lawsuits. However, IRAs, while having some protection from cases such as bankruptcy, have fewer protections from creditors and the rules defer from state to state. If you have a significant amount of debt, then leaving as much money as possible in a 401(k) could help protect your nest egg.

David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.