401K vs. Roth IRA: How Should You Save?

Have you thought about how you should direct your retirement savings? You should. There’s a variety of ways to save, and you should find the best way. For example, should you max out your 401K contribution? And I’m not just talking about getting the company match. I’m wondering if you should save beyond the match, or would you be better off putting you extra savings in a Roth IRA?

A lot of this depends on your income tax rate. For example, your tax bracket now plus state income tax rate can have a big effect on the optimal way you save for retirement. That’s because 401K contributions are tax deductible. If you make $100,000 per year and contribute the maximum $18,000 to a 401K, the IRS only taxes the remaining $82,000. That gives you a tax benefit now.

Let’s take a hypothetical situation where you could save $1,000 per month for 20 years earning an 8% return on investment. If you invest in a Roth IRA or on your own, you can save $1,000 per month. But if you want to save via your 401K, you could really invest more than $1,000 because of the taxes you save now. So you can invest $1,000 / (1 – your tax rate). Below is a table that shows possible saving per month under different tax regimes.

If you can afford $1K per month, you can really afford the below per month:

Tax rate now	401K	Roth IRA	On own
Tax @ 15%	$1,176	$1,000	$1,000
Tax @ 25%	$1,333	$1,000	$1,000
Tax @ 28%	$1,389	$1,000	$1,000
Tax @ 34%	$1,515	$1,000	$1,000

You may wonder why I added 34% as a scenario. That’s because you could live in Oregon with an income tax of 9%. If your family’s income brings you into the 25% federal bracket, and you can save $1,000 after taxes, by doing so before the 34% you pay to the Feds + Oregon, you could really afford funding your 401K at $1,515/month and have the same amount of after-tax income.

At 8% return on investment, how much would you have after 20 years with the above month savings?

Tax rate now	401K	Roth IRA	On own
Tax @ 15%	$646,051	$549,144	$549,144
Tax @ 25%	$732,191	$549,144	$549,144
Tax @ 28%	$762,700	$549,144	$549,144
Tax @ 34%	$832,036	$549,144	$549,144

You can see that in the Oregon situation (34% tax), you would have $282,892 more by saving via a 401K than either via a Roth or on your own. Why? Because the tax deduction helps you save more earlier, and that more grows by 8% over 20 years. Amazing, right? Of course you should save with a 401K.

Not so fast. you could have a lot more money on paper, but you’ve never paid tax on that 401K. That means as you distribute the money in retirement, you may not have as much as if you’d taken one of the other options. So let’s explore these scenarios further.

We want to know the income each cash pile would create in retirement and after tax. If you have a Roth, you won’t pay any taxes on distributions. If you invest on your own, you only need worry about qualified dividend or capital gains taxes. For the 401K, you have to pay income tax on all your distributions.

Let’s make a few more assumptions.

1. Let’s say you can get a 5% dividend in retirement.
2. Also, you’ll only distribute that dividend without making any capital gains, and without touching your principal.
3. Also, we’ll assume your tax rate changes to either 25% tax in retirement (because you’ll move to a no-income-tax state like Washington), or a 15% qualified dividend tax. What will you make then?

At 5% dividend, just distributing the dividend, you would earn this per month net:

Tax rate now	401K	Roth IRA	On own
Tax @ 15%	$2,019	$2,288	$1,945
Tax @ 25%	$2,288	$2,288	$1,945
Tax @ 28%	$2,383	$2,288	$1,945
Tax @ 34%	$2,600	$2,288	$1,945

In the situation of the Roth IRA, you won’t pay any taxes. That’s the beauty of the Roth. If you invest on our own, you’ll probably end up at a 15% qualified dividend tax rate (assuming you have other income from Social Security or some part-time consulting or what not). With the 401K you pay a 25% income tax on the distributions.

Because of my assumptions, you’re worse off with the 401K at a lower working-age-tax rate. But you’re better off as your working-age-tax rate increases. In fact (and I checked the numbers), if you pay the same tax rate in retirement that you did while working, the dividend income you generate between your Roth and your 401K becomes a wash.

However, it’s a poor assumption that you’ll make the same amount of money in retirement as now. That’s because you don’t expect to have a mortgage or child care expenses in retirement. You also won’t have to save for retirement. Without those incentives (or needs) to earn more, you probably won’t. In fact you’ll earn much less with more freedom to live in a lower-tax environment.

That means it’s much better for you to avoid taxes during your peak working years by contributing as much possible to a 401K. If you can save more than $18,000 per person (going over the maximum yearly 401K contribution), then move onto saving via a Roth IRA. How much of a difference would it make from just saving on your own without using a 401K or Roth?

% different in investing in a 401K or Roth IRA over simply saving on your own

Tax rate now	Tax rate retired	401K	Roth IRA
Tax @ 15%	Tax @ 25%	3.8%	17.6%
Tax @ 25%	Tax @ 25%	17.6%	17.6%
Tax @ 28%	Tax @ 25%	22.5%	17.6%
Tax @ 34%	Tax @ 25%	33.7%	17.6%

If your tax rate goes up in retirement, you would be better off contributing to a Roth IRA. But a realistic situation – higher tax rate now, lower tax rate later (we’ll use 34% rate now, 25% rate after you retire), you would earn 17.6% more in after-tax dividends using a Roth IRA over just saving on your own. But a 401K would earn you a whopping 33.7% more. That’s $655 per month.

How would you figure out your own benefit from contributing to one scheme over another? Understand your top tax bracket now. Figure out how much more you could save by switching to saving via a 401K. Then try to guess your tax rate when retired. It could make a huge difference.