Tuesday, April 18, 2006

Which is better, a 401(k) or a Roth IRA?

I thought we might celebrate putting tax season behind us by taking a look at two of the most popular tax advantaged savings vehicles commonly available: the 401(k) and the Roth IRA. If you cannot take advantage of both vehicles, we will see that in most all cases, the Roth wins, but, I qualify this by saying that it still depends on your personal finance circumstances.

Like most people, I am depressed when I look at my paystub and realize how much I pay in taxes. I was suprised, however, to learn that taxation is actually the greatest expense you have over your life. I always assumed it was a home purchase. After all, you usually spend north of $300 or $400, and that's before remodelling and mortgage interest. But when you think about it, you pay personal income taxes (federal, state, and sometimes local), payroll taxes (FICA, Medicare, disability, unemployment), real estate taxes and sales taxes. Add it up, and its a big bite out of your earnings.

Given that taxes are your largest expense, any investment strategy must look both minimize the amount paid, and also offer control over the timing of those payments. As we will see, the Roth is almost always superior to the 401(k) on the first count, and always superior on the second.

Let's first look at the differences in taxation. A 401(k) allows you to take a portion of your income and defer taxes on it, by putting it into the account (before-tax, or "qualified" money in the parlance of the IRS). When you turn 59.5, you may make withdrawals at will. You pay "ordinary" income tax (that is, you pay earned income tax, not capital gains tax). Readers of this blog know that income taxes are taxed at higher rates than (long-term) capital gains or dividends. On the other hand, you have the advantage of tax deferral, and compound that money.

The power of compounding is a powerful thing, and tax deferral is a major benefit to investment returns, because you are essentially able to play with the government's money to earn more money. Tax deferral is a interest-free loan, by the government, to you, the investor. Consider the difference between investor A and B in the following example: both investors begin with $100. Investor A, opens a regular brokerage account and earns 10% per year, and pays 30% in taxes every year, while investor B invests his money inside of a 401(k), defering his tax until he retires, at which time he also pays 30% in taxes. After one year, investor A has $107 ($100 plus $10 in gains, less $3 in taxes). After two years, investor A has $114.49, and so on. After one year, Investor B has $110 (and defers $3 in taxes, which are still owed, but can be reinvested). After two year, Investor B has $121 (with $6.3 in deferred taxes, which can be reinvested yet again). You can see that as the deferred amount is compounded, Investor B's advantage multiplies. If Investor B were to take his money out, after two years, he would have $114.70, or $0.31 more than investor A. After ten years the numbers look like this:

Year A
1 $100.00
2 $107.00
3 $ 114.49
4 $122.50
$ 133.10
5 $ 131.08
$ 146.41
6 $140.26
$ 161.05
7 $150.07
$ 177.16
8 $160.58
$ 194.87
9 $ 171.82
$ 214.36
10 $ 183.85
$ 235.79
after taxes $ 183.85

Investor A has been dutifully paying his taxes every year, but investor B has used the government's tax loan to increase his returns. The three dollars he didn't pay in year one earned an extra 30 cents in year two, and the six dollars and 30 cents in year two earned 63 cents in year three. After ten years, he's ahead by $11.21. Now, imagine that instead of a 100 portfolio, that it was a $100,000 portfolio; that $11 is now $11,210. And imagine that instead of ten years, we were talking about 40 years: the difference between the two investors results is $1500! This is a serious benefit. And actually, since the 401(k) investor (Investor B) received a tax deduction for his CONTRIBUTION as well, on an after-tax basis in the contribution year he should have started with $130, not $100. This lifts his advantage by an additional $850, for a total of $2350!

This principle is one of the reasons that many investors prefer capital gains (stock price appreciation) to dividends. The gains in stock prices can be deferred indefinately - until the asset is sold. It gives you, the investor complete control over when you pay your taxes.

The Roth is a slightly different animal. With a Roth the government makes a GIFT of your taxes (earnings are Tax Free, not simply tax deferred). For this benefit, however, you have to pay taxes on your contributions (this is a significant cost). If your investment horizon is short - you often do better off with the 401(k), especially if you expect to be in a lower tax bracket in retirement. (I believe that this is unlikely, and that we are likely to face higher taxes in the future, not lower taxes). Young people, who tend to have lower earnings and are therefore in low tax brackets, also do better, since, for making the small payment of tax on their contributions, they get all of their earnings tax FREE.

But the Roth has anothe benefit: no mandatory withdrawals. With a 401(k), the government is loaning you the money. Eventually, the government wants to be repaid, so at 70.5 you MUST begin withdrawing money, even if you don't need it. With the Roth, since the government has gifted you the money, you never have to make withdrawals, and the account balance is excluded from your estate, so there are no estate taxes to pay, if you leave it to your heirs.

Finally, you can always withdraw your contributions to the Roth tax and penalty free, provided that they have been in the account for at least five years, so in an emergency, you can get at the money less expensively.

The flexibility and the tax free nature of earnings makes the Roth a clear winner here.

Chances are, if you have money in both vehicles, the 401(k) has a bigger balance. That is because the 401(k) does have a few advantages. The most obvious is that it has higher contribution limits than an IRA. $15,000/year in employee contributions for 2006, and $20,000 for people over 50, who are entitled to "catch-up" contributions. Your company may impose lower maximums, however. Usually, companies do this to ensure that the 401(k) plan does not descriminate in favor of highly compensated employees. That is, the government doesn't want 401(k) plans where everyone outside of top management contributes $2000 a year, and top management uses the tax deferral to stuff $20,000 in the account. Such a plan, the government reasons, is not a corporate savings plan, but an executive deferred compensation plan (which has separate tax rules).

Another critical feature of a 401(k) is that, since it is an employer sponsored plan, employers often offer a matching contribution. (This amount does not count against the $15/$20,000 mentioned above - those are limits for employee contributions. Total contributions - both employee and employer - cannot exceed 25% of an employee's gross salary). The employer match is an important return-booster. If someone is offering you a 50 or 75% match, this is essentially offering you a guaranteed 50 or 75% return for the first year. You really cannot beat it, even with the tax advantages of the Roth, so my recommendation is that you contribute to a 401(k) until you get the maximum match.

There is one downside to this, however, which is that you are limited to the investment choices selected by your employer. They may be limited, and in some cases, inappropriate.

Finally, while this probably doesn't apply to readers of this blog, contributions to a 401(k) are usually automatic, and done as payroll deductions -before you even get to see the money in your paycheck. This makes the contributions regular and easy, which means that you are more likely to stick with your strategy.

So, 401(k) or Roth? Why not both? If you like the options that your employer offers, get the match. Then fund the Roth until you hit the limit, and then you have to decide if you want to max out your 401(k) before funding a regular, taxable, brokerage account.


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