401k Versus Roth - A New ER Ratio!
So you are one of those people who can afford to save some money, but you are bewildered as to which investment vehicle will be your best bet... pre-tax 401k or post tax Roth IRA. I hate to break it to you but there is no 'one size fits all' answer.
Before I get into the decision discussion, I need to make sure you are ready to make such a decision. Make sure you are doing the following...
- You should be contributing enough to your company's 401k to get the company match. This is free money and usually a great deal. My company will contribute 4% of my salary if I put 5% or more into my 401k... that's a risk free 80% return on my investment!
- Your non-mortgage consumer debt (credit cards, car loans, etc.) should be at interest rates below the average return for the market (8-12%). If you are paying 18% interest on your CCs, use your extra money to pay-off that debt.
- You are spending less than you earn.
OK... so we're talking about whether you should invest your money in a 401k or Roth. Let's make sure we're all on the same page as to our definitions of each account:
- employer sponsored
- pre-tax contributions- that means no federal, state or social security taxes are withheld from your earnings if they are contributed into this account
- tax deferred - you don't pay taxes now - but when you withdraw this money, it will be taxed like normal income
- $14,000 annual contribution limit (more for older folks)
- you can pick one up at your broker or bank
- income limits - if your AGI exceeds $150k (married), you cannot contribute
- post-tax contributions - you use money from your after tax earnings to fund this account
- tax free earnings - you will not pay any earnings on the investment gains if you wait to withdraw the money in retirement
Both of these investment accounts have a bunch of restrictions and rules which are important but won't be covered in this article. Read your plans' rule carefully, blah, blah, blah.
So... I've worked-out the math on which account is more advantageous. It's easier than I thought it would be:
x= marginal tax rate today
y= marginal tax rate when you retire
TERRAR (The Early Riser Retirement Account Ratio) = (1-x) / (1-y)
TERRAR tells you the after-tax value ratio of a tax-free Roth compared to a tax deferred 401k. If the TERRAR is <> 1, you should go with the Roth. Let's do an example...
x= today's marginal tax rate = 28%
y= retirement marginal tax rate = 15%
TERRAR = (1-0.28) / (1-0.15) = 0.72 / 0.85 = 84.7%
This would tell me that my after-tax R0th balance would be 15.3% less than my after-tax 401k balance.
Easy... right? Well, you ask, how do I know my marginal tax rate when I retire? Good question. For the older folks in the audience, you should estimate your annual retirement income and look at the current tax tables. For those of us who are 20 or more years away from retirement, you have to be a fortune-teller.
Ratio - smatio you say... give me some practical advice! OK... here's where I would put my money in descending order:
- Employer Stock Purchase Plan - slam dunk if the terms are favorable
- 401k to get employer contribution - you should put enough in to get the employer match
- pay off all debt is APR over 10%
- split remaining $ between 401k and Roth
Remember, everyone's financial situation is different. There are significant estate impacts to these different investment vehicles. If you are unsure about what to do, go find yourself a fee-only financial planner to work-out the numbers.