investing » The Art of Money

Roth IRA or 401(k): Which is Better?

Nov 052011

For gainfully employed young professionals in their 20’s, the two most attractive retirement investment vehicles available are the 401(k) and the Roth IRA.

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

2) Max out your Roth IRA*

*the current limit is $5,000 per year, assuming you file as an individual earning less than $107,000 per year.

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!

The Difference Between an Asset and a Liability

investing 2 Responses »

Oct 272011

Why would you need to know the difference? Well, after reading Robert Kiyosaki’s definition of an asset and liability in his book Rich Dad Poor Dad: What The Rich Teach Their Kids About Money – That The Poor And Middle Class Do Not!, it completely changed the way I think about finances.

You see, the traditional accounting definition of an asset includes things like your house, car, golf clubs, computer, flat screen TV, etc. If you ask most accountants to calculate your net worth, they will tabulate 75% of the supposed market value of these items, as well as the difference between the home resale value and the amount you owe on your mortgage. This is how people get to say, “I have a net worth of $100,000!” even if they have $10,000 in credit card debt and are living paycheck-to-paycheck.

While this is technically accurate according to traditional accounting standards, this definition is NOT useful for the layperson who just wants to make better financial decision. The reason is that it dupes you into thinking you’re richer than you are.

Robert Kiyosaki suggests an alternative definition of an asset and liability that I’ve found infinitely more useful. Here it is:

Asset: something that puts money in your pocket every month.
Liability: something that takes money out of your pocket every month.

By this definition, if you’re paying $1,000/month on your mortgage, your home is a liability, NOT an asset. If you owned and lived in a duplex where rental income exceeded your mortgage by say, $200/month, then your home is an asset, because it puts $200/month in your pocket every month.

Similarly, all your crap that your accountant will count as “assets” are really liabilities by this definition. Your car may deliver real benefits to you in that it gets you to work every day, but if it takes money out of your pocket every month in the form of loan payments, gas, insurance, maintenance and repairs, then it’s a liability.

The maxim then becomes simple: spend your life buying assets, not liabilities.

Most people do the exact opposite. They trade their time for money in the form of a job, and use that money to buy liabilities. Wealthy people may start off that way, but they spend their life buying assets that put money into their pocket every month, and eventually they don’t have a traditional job, because they receive enough income from cash-generating assets that they don’t need to work.

For all you visual learners, here is a video by Mr. Kiyosaki himself explaining the difference: