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Reader Mail: What’s better for me – a 401(k) or Roth IRA?

by J. Money on Tuesday, April 7, 2009

Reader MailYou all know how much I LOVE my 401(k), but what about our friend the Roth IRA? Both investing vehicles are sexy in their own way, but how do you know when to use one over the other?

The answer to these questions always lies within the situation at hand – and it just so happens we’ve got one today. The odds? ;) A fellow reader hit me up recently and wanted to know what we thought about her dilemma. Here’s what she sent:

“I graduated from college in December and am in my first “real” job with benefits. I am a teacher. I am required by the union to contribute to the teacher’s pension. In addition to this, I have the option to have a 401(k) and the employer does not match contributions. My thought is to skip the 401(k) and simply open a Roth IRA. Is this a good thought? In any circumstance would I want to pick a 401(k) over a Roth IRA? (Besides the obvious employer matching) What made me start thinking this path was an article I read on Kiplinger about Roth IRAs and one of the benefits is that you can use it to help save up for a first home, and this is another goal in the somewhat near future of my life.”

First off, I’m impressed you are already thinking of this at a young age! Good for you. This topic has been debated like crazy amongst the finance world, but it really comes down to your goals here. Both 401(k)s and Roth IRAs are awesome as hell, and both have their pros and cons. For anyone who’s not familiar with them, here they are in a nut shell:

401(k)s – All money that goes here are pre-tax, meaning not taxes come out while investing. This is great in that you have MORE money to invest and accumulate over time because you have that additional 25% (or whatever your tax rate is) earning money for you. 401(k)s are also great in that your employer will usually match you up to a certain % (as mentioned in your email) meaning you get FREE money. On the flip side, you have to pay taxes on this once you start drawing out the money in retirement. You will also get charged up the a$$ if you take any money out before you’re eligible. There are some sneaky ways here and there where you could, potentially, take out some money w/out incurring this wrath, but I wouldn’t advise it.

Roth IRAs – Another investing tool that allows you to save for retirement, and sorta like the opposite of 401(k)s in that you get taxed UP FRONT, but you never have to pay a tax again down the road! So say you drop in $5k and then leave it alone. In 30 years that $5k can become $20k and you don’t have to pay a cent on that $15k of earnings :) On the flip side, you can only put in a certain amount each year ($5k for 2009 if you’re under 49 vs $16.5k for 401ks ), and you can’t make over a certain amount of money (a bit over $100k)

But back to your question. Whether you choose a 401(k) or a Roth IRA comes down to your future plans. If you want to invest for RETIREMENT, meaning you won’t touch it for 30+ years, then I’d open up both a 401(k) and a Roth and leave it alone (you can add more to one over the other, but I always suggest having both).

In your case, it looks like you will probably need this money for a down payment on a house sometime soon. So dropping $ in a 401(k) is def. not the way to go (after you contribute up to your employer match to get that FREE money). In fact, I probably wouldn’t even go with a Roth either since its main use is for retirement funds as well. If it were me, and I were definitely getting a house in 3-5 years, I’d throw the main chunk of extra money into a high-earning savings account like ING or another online bank since you’ll be dipping into it soon.

That being said, you’ll probably end up opening up a retirement account anyways cuz it looks like you really want to ;) In that case I’d recommend going with a Roth. While it’s not designed to be used like that, at least according to my accountant when I asked her last year, you *can* take out any $ you have contributed at any time w/out incurring any fees or taxes – you just can’t take out any interest earned. (there are certain situations where you CAN take out all of it – like a home or hardship – but you have to make sure the account’s been open for at least 5 years. I’d talk it over w/ a professional)

So if you want to save save save and then take out the contributions when you need that down payment, the Roth is the better option here between the 2. Would you all agree?


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