401k versus Roth

Investing
#1

Hi Jeremy. In your “ultimate investing checklist” Roth IRA is before 401k/403b. Why is it more beneficial to do it this way when making out 401k/403b gives you a tax advantage and Roth IRA contributions don’t? Thank you so much!

#2

Hey Emira!

WELL, the Roth IRA DOES give you a big tax advantage! That’s the point. There’s two main types of tax advantages: “Traditional” and “Roth”. The 401k you’re thinking of is “Traditional” in that in reduces your taxable burden the year you make the contribution. Then the money grows tax free until retirement. But when you withdraw the money in retirement ALL of the money is taxed.

Roth is kind of the opposite. You don’t get any tax break now, but once the money is in the IRA it grows tax free FOREVER and you never pay tax on it again, even when you take it out. So it’s like tax now, vs tax later. Which is better depends on your tax bracket now and later, and the tax rates. It’s impossible to know what the future will hold, but generally Roth comes out better for most people. Here’s a look at how the different tax breaks work:

One other note is that BOTH IRAs and 401ks can come with either type of tax break. You get to choose! (Not every company offers a Roth 401k/403b though):

So to your question: Why do I prioritize the IRA over the 401k? The answer is a few things:

  • Lower fees: IRAs are individual accounts so you can open them with low fee brokerages like Vanguard, Fidelity or Schwab. Your 401k/403b generally has to go with the provider your employer chose and they often have higher fees.
  • More investment options: 401ks generally only let you choose from a few investment options selected by your employer. They potentially aren’t as good as a low fee index fund you can buy through an IRA
  • No employer ties: All things equal, I wouldn’t want my retirement money tangled up with my employer. There’s no benefit and can cause more paperwork or hassle when you leave the company. I’d prefer to have my money in my account!

So that’s why I prioritize the Roth IRA over 401k/403b! But, to be clear, they’re both good. If you do nothing but a 401k your whole life, and you invest early and often you’ll still be rich. It’s more of a fine tuning thing on the exact order.

1 Like
#3

Thank you for all the details!