Which one should you choose? Should you invest 100% in one or the other, or split the two? I’ll answer those questions in this blog post.
I hope you’re already taking advantage of the magic of compound interest, but if not, I’ll offer a quick example to illustrate the importance of saving EARLY.
- John is a 25 year old that invests $100/month into a retirement account and lets it compound at 8% for 40 years. He will end with $380,000 to retire on.
- Jane is a 45 year old that invests $100/month into a retirement account and lets it compound at 8% for 20 years. She will end with $65,000 to retire on.
In other words, just 20 years of not investing cost Jane $315,000! Use this free compound interest calculator to run your own numbers.
OK, so we know we should save for retirement, but the question remains: 401(k) or Roth IRA?
401(k) BENEFITS
The 401(k) offers one primary advantage: the company match. Many companies offer an employer match up to a certain percentage of your income. For example, if your employer will match dollar-for-dollar your 401(k) contributions up to 6% of your monthly income, and the maximum you can contribute is $100, your employer will ALSO invest $100 into your 401(k), for a total of $200/month.
As an example, let’s take John and Jane again, where John has a 401(k) with employer match and Jane does not.
- John invests $100/month with a dollar-for-dollar employer match for a total of $200/month and lets it compound in a retirement account at 8% for 40 years. He will end with $710,000.
- Jane invests $100/month without an employer match and lets it compound in a retirement account at 8% for 40 years. She will end with $355,000.
By taking advantage of the employer match, John doubled his money and earned an additional $355,000!
ROTH IRA BENEFITS
The primary advantage for the Roth IRA is that you can withdraw the proceeds tax-free. If you anticipate earning more money and being in a higher tax bracket as you get older, then contributing to a Roth IRA will mean more money in your pocket. Using a Roth IRA vs 401(k) calculator from Bankrate.com, I calculated the difference for my financial situation:
At my current salary, I’m paying 15% of my wages in federal income tax. Assuming a 28% tax rate when I retire, contributing to a Roth IRA will net me $36,749 more than if I had contributed the same amount to a 401(k). Remember though, that this DOES NOT calculate the value of the employer match mentioned above.
A secondary benefit of the Roth IRA is that you can withdraw the principal at any time, tax and penalty free. This means your Roth IRA doubles as an emergency fund, but earns WAY better interest over the long-term than any high-yield savings accounts or money market funds out there. I actually used my Vanguard Roth IRA as an emergency fund in 2010 when I withdrew $1,000 of principal to pay down my credit card debt. Not something I’m proud of, but it sure helped me out in a bind.
FINAL RECOMMENDATION
1) Contribute up to your employer match in your 401(k), and then
Do you have a 401(k) and/or Roth IRA? How have you allocated your money between the two retirement accounts? Are you saving for retirement in another way? Please share in the comments!
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