Choosing between 401(k) and Roth IRA
Dear Dr. Don,
Please recommend how much to allocate retirement savings between a 401(k) plan and a Roth IRA. How do I choose between the two, assuming there is no employer match in the 401(k) plan?
-- Arul Assigns
With no employer match, your choice is similar to the decision between a traditional IRA and a Roth IRA -- at least up to the contribution limits of an IRA account. In general, you want to contribute on a tax-deferred basis if you expect your marginal federal income tax rate to be lower in retirement than it is today. If you're in a fairly low bracket now, then making after-tax contributions to a Roth IRA allows you to take qualified tax-free distributions in retirement.
Another reason to contribute to the Roth IRA is if you don't expect to need the money in retirement because Roth IRAs aren't subject to required minimum distributions.
Employee contributions to a 401(k) plan are made with pretax dollars. Contributions to a Roth IRA are made with after-tax dollars. To put the contributions on an apples-to-apples basis, you need to invest the tax savings benefit from contributing to the 401(k) plan. Said another way, if it costs $8,000 in gross salary to contribute $6,000 to a Roth IRA, you'd want to compare that investment with a $6,000 contribution to your 401(k) plan that resulted in a $1,500 reduction in your federal income taxes due for the year. You would invest the $1,500 tax savings for retirement. (I assumed a 25 percent marginal federal income tax bracket and no state income taxes.)