Roth IRA Versus 401(k): The Great 20-Something Debate

Written 4/5/11 for Minyanville.

 In my last post, I mentioned that saving is one of the first steps to take toward a financially secure future. Specifically, invest in a 401(k) if your company offers one.  The money goes in automatically pre-tax (you can even pretend it doesn’t exist), and usually the company matches a percentage of what you input. Any percentage you invest is better than nothing. Find out the max amount your company will match and aim for that. Or you can do a Roth IRA, with money that’s been taxed in your paycheck already. The max is $5K per year. You can also do a combination 401(k)/Roth IRA if you want to diversify and get fancy.

That makes it sound like I know what I’m talking about. The truth is that I have no idea how much I’m contributing to my 401(k). I spent a good fifteen minutes trying to find out on the company’s website to no avail. All I know is that I have one, I’m putting money into it, and that’s good.

I don’t know anything about a Roth IRA except that you invest money (up to $5K) that’s already been taxed as I said above. What does that even mean? And who in his or her 20’s has $5K lying around? Definitely not me.

So this week I’m looking at the difference between a 401(k) and a Roth IRA, the pros and cons of each, and then deciding how much I personally should be investing in my 401(k) (after calling to find out what percentage I already contribute. Homework, ugh.), and then figure out whether a Roth IRA is something I should do too. It’s not like 401(k) and Roth IRA are the only retirement fund options. There are tons of others, but these are the two I hear about most often.

Of course, it’s different for everyone, but hopefully my research will help you out and we can get beach chairs next to each other when we retire at 59.5.

A Roth IRA is an investment account, in which you invest money that has already been taxed as part of your regular paycheck into stocks, bonds, index funds etc. It’s then managed by a brokerage firm. Easy enough.

Pros: The cool thing is that whatever you gain in there is tax-free when you take it out later in life because it was already taxed before you put the money in. If you can afford to put in the max $5K every year (that’s less than $100 a week or about $14 a day) and let’s say you’re 25, you will have $200K by the time you’re 65. But you’ll also have gains and interest, which have accumulated on your money over time.

Our 20-something financial guru Marc Bodinger says “If you take it seriously and contribute the max annually you should have a million by retirement.” There are also more investment options, like common stock, mutual funds, bonds, and ETFs, versus a 401(k), which may only offer mutual funds.

Cons: Your Roth IRA investment is not matched by your company. Like the 401(k) you have to leave the money in the account until retirement, or you’ll face penalties. There are some exceptions, but I suppose you could say it’s frowned upon. You can take out the original amount you invested if you need to without penalty. There’s a chart on Smart Money  that shows when you’ll face penalties and what the exceptions are.

How to invest in one: You have to call a broker (TD Ameritrade, Charles Schwab, your local bank, etc.) to open an account. You can’t just waltz over to HR tomorrow morning unfortunately. Some of them have a minimum amount you need to invest, so decide what you can invest and see who will work with you. If you’re going to put in $5K in a year, you just have to do it by April 18^th. Then a new year starts. It’s probably best to direct deposit either from your paycheck or your bank account into the Roth IRA, so you actually invest in it and don’t forget. If $5K sounds like way too much because you’re paying student loans, rent, and hardly make anything, that’s okay. Just invest what you can. If it’s $100 a month, you’ll learn to live without it and you can rest assured that the money is growing for you and you don’t have to do much of anything. Make it goal to do this with your next raise or bonus or birthday money.

401(k): An investment company, such as Fidelity or Principal, manages 401(k) cash money. They will give you different options. There are some already set up and you can choose based on your age. Or you can pick your own options (stocks, mutual funds, international) to throw in the basket if you don’t like the pre-packaged choices. Obviously I have a pre-packaged choice, because I wouldn’t have a clue what to choose for myself.

Pros: With a 401(k) less of your income is taxed now, since the dollars go into the account pre-tax and then grow. You can deduct this investment from your taxable income, so really you’re saving money by saving. If your company matches the money you invest, that’s just free money for you. For example, if you invest $2,000 and your company has a 1:1 match, you really have $4,000. You can have the money taken right out of your paycheck, and all you have to do it talk to HR at your company. Oh, and if you leave your current job, you can just take your 401(k) with you. You don’t want to cash out until retirement, but the investments will roll over for you, even between investment companies.

Cons: You do pay taxes on your 401(k) dollars when you take the money out though in retirement. It counts as regular income tax that year. And if you log off of Facebook for five seconds so your career goes well, you’ll be in a higher tax bracket by then, so that will be a big tax year for you considering taxes are likely to increase in the next 40 years.

How to invest in one: Go to HR and ask for an application. Find out how much your company matches, if you have to be at your company for a certain amount of time before they match, or if you have to invest a certain percentage for them to match. Try to invest so you get the max amount matched by your company for free money!

So 401(k) or Roth IRA?

Marc says, Both. “We will need both upon retirement anyways. I’ll bet on that.”

Another young financially savvy attorney also says both. “You pay taxes with both. Bottom line. It’s just you pay taxes at different times. If you put your money in 401(k),  taxes could increase, then you’re paying more. If you put your money in Roth IRAs you lose out on the company matching your pay. My personal belief is that it’s never smart to have all of your money in one place.”

If your company doesn’t offer a 401(k) or match your contributions, it looks like a Roth IRA is a good alternative.

In any case, you have to do something. You can’t rely on social security or the government to take care of you in retirement. You have to plan ahead. If you open a 401(k), Roth IRA, both or something else, you’re giving yourself an advantage in terms of taxes, growing your money, and keeping your head above water. No one is saying it’s a fun time. It’s not like you get to take the money out and buy a new iPad every few months. But you’re saving for your future. Not only saving, but accumulating. And it’s not extra work once you set it up.

Start now though, because if you figure you’ll wait a few years until you make more money, you’re losing out on thousands that could be accumulating while you procrastinate and whine about not having money to save. It looks like the only way to get rich besides making a lot of money is investing in something that makes your dollars multiply. Money may not grow on trees, but it does grow in retirement accounts. Seems kind of like a magical no-brainer.

Choose Your Nest Egg Nest

Trusted Sources: Bankrate.com and iwillteachyoutoberich.com