Roth 401(k) compared to Roth IRA

Question

Is there any benefit to investing in a Roth 401(k) plan, as opposed to a Roth IRA?

I currently have a 401(k) plan at work that has a (very generous) 6% salary match on contributions, with no vesting period on those matches, so I've been paying a lot of attention to investing options lately.

I've decided I want to make my 401(k) contributions into a Roth 401(k) account, which is an option at our company, because I'm currently 21 and the earnings on that account compounded over the next 40 years growing tax-free will be much higher than what I'd save on current taxes on a traditional 401(k).

However, I'm somewhat put-off by the idea that I can't withdraw any money from a 401(k) plan (Aside from loans which must be repaid) without paying taxes and a penalty, before I'm 59 and 1/2 years old.

I recently read that a Roth IRA allows you to withdraw your contributions, but not your earnings, penalty-free at any time, even before that age limit.

I'm starting to think that because of this, the Roth IRA would be preferable for me to invest any remaining earnings that I don't currently need into, as if I do run into a situation in the future where I need to withdraw money from it (purchasing a home, paying for education expenses, something generic like purchasing a car), I won't have to worry about paying additional taxes or fees.

What other benefits do a Roth IRA or Roth 401(k) have compared to each other? I had previously thought they were more or less the same, and am looking for more information about why one might choose one over the other.

I'm currently planning on putting 6% of my salary into the Roth 401(k), to make use of the company 401(k) match, but am thinking I will put anything else I'd like to invest (up to the $5500/year limit) into a separate Roth IRA to invest and have tax-free earnings but also have the ability to withdraw my contributions if something comes up in the future.

Please let me know your thoughts on this, it's a fairly large / broad topic so it's hard for me to get all of the pro's / con's of each option when it comes to retirement and/or investing.

Answer 1

Is there any benefit to investing in a Roth 401(k) plan, as opposed to a Roth IRA?

They have separate contribution limits, so how much you contribute to one does not change the amount you can contribute to the other. Which is relevant to your question because you said

the earnings on that account compounded over the next 40 years growing tax-free will be much higher than what I'd save on current taxes on a traditional 401(k).

This is only true if you max out your contribution limits. If you start with the same amount of money and have the same marginal tax rate in both years, it doesn't matter which one you pick.

Start with $10,000 to invest. With the traditional, you can invest all $10,000. With the Roth, you pay taxes on it and then invest it. Let's assume a tax rate of 25%. So invest $7500.

Let's assume that you invest either amount long enough to double four times (forty years at 7% return after inflation is about right). So the traditional has $160,000 and the Roth has $120,000.

Now you withdraw them. For simplicity's sake, we'll pretend it's all one year. It's probably over several years, but the math is easier in a single year. With the Roth, you have $120,000. With the traditional, you have to pay tax. Again, let's assume 25%. So that's $40,000, leaving you with $120,000 from the traditional. That is the same amount as the Roth!

So it would make sense to

1. Get the entire employer match in either form of 401k.
2. Max out your Roth IRA contribution (possibly as a backdoor).
3. Any money you have left to invest, put in your 401k.

If you can max out both, great. You do that for forty years and your retirement will be as financially secure as you can make it. If you can't max them out, the most important thing is the employer match. That's free money. Then you may prefer your Roth IRA to the 401k.

Note that you can also roll over your Roth 401k to a Roth IRA. Then you can withdraw your contributions from the Roth IRA without penalty or additional tax. Alternate source.

Beyond answering your question, I would still like to reiterate that Roth or traditional does not have a big effect on your investment unless you max them out or you have different tax rates now versus in retirement. It may change other things. For example, you can roll over a Roth 401k to a Roth IRA without paying taxes. And the Roth IRA will act like it was contributed directly. You have to check with your employer what their rollover rules are. They may allow it any time or only at employment separation (when you leave the job).

If you do max out your Roth accounts, then they will perform better than the traditional accounts at the same nominal contribution. This is because they are tax free while your returns in the other accounts will have to pay taxes. But it doesn't matter until you hit the limits. Until then, you could just invest the tax savings of the traditional as well as the money you could invest in a Roth.

Answer 2

If your budget allows for it, max out both plans!

However, in my opinion, you're on the right path:

1. Put in 6% into Roth 401(k) to get max company match
2. Max out Roth IRA contributions
3. If budget allows, contribute to Roth 401(k) over and above the initial 6%, up to $18k (assuming you're not of age to get the catch up contribution provision)

The advantage of also contributing to the Roth 401(k) in this case would be:

• Get company match
• Increase amount that can be invested tax-free

This second point is the main reason that you should also invest in a 401(k), using that as a retirement savings vehicle alongside your Roth IRA.

One caveat is that you should ensure that you'll have sufficient savings so that you won't need to dip into either plan - it'd be a shame to reduce the investment base from which you can grow your savings tax free. Personally, I'd view my contributions in the Roth IRA as an emergency fund to be used only in the direst circumstances.