Invest In Roth IRA Or 401k?

Reader Question

Hello LTR. Great website and resources. We (33 and 34) have a question on:
1. Max out both ROTH IRAs and up to company match [in 401k].
2. Max one Roth IRA and up to company match and contribute the extra $5k to 401K.
3. Contribute up to 401K match, use extra funds to pay off car loan at 2.99%, with $25K remaining. pay off date is Nov 2016. Once car loan paid off saving rate will nearly double per year.
4. Contribute to one ROTH IRA and up to company match in 401k and just continue savings.
5. Continue with just 401K contributions and save for my 69 Chevy Chevelle. No plans for new car no time soon. LOL

Combined Salary: 121K tax rate: 25% one kid: enters college in 7 years. emergency fund is good debt: mortgage (3.25%, 15 year) and car loan (2.99% 25K remaining, payoff date Nov 2016) current combined 401K amount: $48k Total Contributions (including employee match) per 401K year: $12,111. Savings Account contributions per year: $9K retirement date: 60-62. Thank you. I am torn between option 1 or 2. Thank you

My Reply

Thanks for writing, glad you found my blog useful. First things first. Let's confirm that options 1 and 2 are really the best ones...

Roth IRA takes precedence over the 69 Chevy Chevelle -- that eliminates option 5.

Option 3 may seem like a good way to go because you will not find any other guaranteed investment that will return 2.99% a year by 2016 -- especially after taxes (since car loan is not tax-deductible -- unless it's a business vehicle which I don't think it is). However then you'd be losing out on $25,000 of tax-advantaged space that you will never again be able to regain. In the long run this tax-advantaged space will almost certainly be worth a lot more than the $1,000 or thereabouts you'd save by paying off the loan ahead of schedule. That takes option 3 out.

Option 4 is out because unless you have dire need to build up an emergency fund (and you don't) it never makes sense to invest in taxable space instead of Roth IRA space (or 401k/Traditional IRA space, for that matter).

That leaves options 1 and 2, between which you are torn. These are most likely splitting hairs, but let's think them through. 401k (similar to a traditional IRA) gives you a tax deduction now but will force you to pay taxes on withdrawals. Roth IRA does not give you any tax savings now, but allows for tax-free withdrawals in the future. If you crunch the numbers you will find that:

• Roth IRA is preferable to 401k/Traditional IRA if your future withdrawal/retirement tax bracket is higher than your current tax bracket
• 401k/Traditional IRA is preferable if your current tax brackets is higher than your future withdrawal/retirement tax bracket.

Roth IRA has some other niceties but they are relatively minor compared to the above calculation. So here is the logic to follow: 

• If you are currently in 15% tax bracket (even if you don't put the last $5K into 401k) after all the pre-tax contributions and deductions then I would definitely go with option 1 and max out both Roth IRAs because it is unlikely that your future tax bracket will be even lower than today's 15%. You are probably not in 15% bracket, so this is a moot point.
• If you are currently in 25% tax bracket (seems likely) then you have to guesstimate what kind of retirement you are looking at. Do you expect to have so much saved and invested by then that combined with Social Security you will be spending much more than you do now (meaning higher tax bracket)? It's possible but your planned retirement in less than 30 years away and you should expect to live another 30 years or even more once you retire. I don't know your career or business prospects, of course, but I would guesstimate that it's likely that your retirement will not be luxurious, with less than $150,000 (in today's money) annual spending -- even with Social Security factored in. That would put you no higher than 25% bracket if tax rates stay constant -- and maybe even 15% tax bracket depending on how the unknowable future unfolds.

So the guess here is that your retirement tax bracket is likely to be same or lower as your current tax bracket. That would have me leaning towards option 2 and contributing extra to 401k instead of maxing out the second Roth IRA. The caveat is that investment choices in your 401k must be as good as what you would invest in Roth IRA -- namely index funds with total expenses in 0.10% range annually. If your 401k choices all have 1.0% and higher expense ratios, then Roth IRA is the way to go, no question. But if your 401k investment options are good then I would lean toward option 2.

Couple more (minor) points in favor of option 2... First, if it turns out that you really do become rich and end up retiring in higher tax bracket then you probably will be just fine, whether or not you make the right Roth IRA vs. 401k choice now. But if you end up having to cut it close in retirement (meaning low tax bracket), then the right choice is contributing to 401k for maximum tax savings. Second -- and this may seem slightly paranoid, but I think it's practical -- it is relatively simple for the government to make Roth IRA withdrawals be effectively taxable even if officially they are not. If we move to a federal sales tax or another VAT-like tax, then the tax-exempt benefit of Roth IRA may diminish (if sales tax/VAT is used alongside income tax) or disappear (if sales tax/VAT supplants income tax entirely). Taking the tax deduction up front with 401k contribution is more of a sure thing.

On the flip side it is possible that future taxes will go up across the board, but then we will all likely be looking at relatively lower savings and investment returns (and Social Security payments) in the coming decades anyway, which means that your retirement will still not be rich. So even if taxes do go up, it's still quite possible that you'll be in the same 25% tax bracket -- just that by then the 25% bracket may start at lower income.

So, to recap, unless you are in 15% tax bracket today or unless your 401k choices are poor (meaning high expenses), based on what you wrote I would go with Option 2 and invest the extra $5K into 401k instead of Roth IRA.