What Is Better: 401k or Roth IRA?

Deciding between a 401k and a Roth IRA depends mightily on your personal financial situation, and also whether or not you have a job or are self employed. If you do have a job, there's no reason to choose between the two types of accounts, as contributing to an employer-sponsored retirement plan does not decrease your annual Roth IRA contribution. If you are self employed, your choice may hinge on how much a plan lets you contribute annually.

Roth IRA Basics

A Roth IRA, or individual retirement account, allows you to contribute after-tax dollars to a tax-sheltered retirement account and use that cash to purchase investments, like stocks, bonds or real estate and deposits, like CDs. You are not taxed on account earnings while the assets and profits remain in your account, and you do not owe taxes on withdrawals you take from your account after you turn 59-and-a-half. As of 2011, you can contribute up to $5,000 to a Roth IRA if you are not yet 50, and $6,000 if you are 50 or older.

401k Basics

The 401ks are employer-sponsored retirement plans that allow you to make pre-tax, or tax-free, contributions to your account. Your employer can either match your contributions or contribute a flat percentage of your annual income. Your assets grow tax free while they are in the account, but you owe income taxes on withdrawals. As of 2011, you can contribute up to $16,500 to a 401k if you are under 50 years old and an extra $5,500 if you are 50 or older.

Solo 401k

Those with jobs get the benefit of both employer contributions and their own elective deferrals. If you are self employed and establish a 401k for yourself, you can make elective deferrals and contribute your company's profits to your account. Here's how it works: image you ran a small business that netted $100,000 in 2011. If you are under 50, you can contribute $16,500 to your 401k. On top of that, you can contribute 20 percent of your profits if you are not incorporated and 25 percent if you are incorporated. Therefore, you could contribute a total of $36,500 to your solo 401k.

Roth 401k

If you are self employed and like the idea of tax-free withdrawals and investment earnings that a Roth IRA offers but need to put aside more than $5,000 or $6,000 annually, consider a Roth 401k. Rather than contribute pre-tax dollars to your account, you pay taxes on your contributions. If you have a profitable company and want to contribute a lot to your account, this can amount to a sizable tax bill. However, if you feel your tax rate will be higher when you retire, it might be worth it.

Considerations

If you are employed, there is nothing to stop you from contributing the maximum amount to your employer's 401k plan and contributing the maximum to your own Roth IRA. However, if you don't have the funds to max out both contribution limits, consider the quality of your employer's 401k. Often, 401ks limit your investment options to a few different mutual funds that may or may not perform well. You can invest a Roth IRA wherever you see fit, and change trustees as often as necessary. Also consider what your employer is willing to match or contribute to your account. If employer contributions are generous, it may be another reason to put more into your 401k.

References

• IRS.gov: Roth IRAs
• IRS.gov: Qualified Plans
• IRS.gov; IRS Nationwide Tax Forum: 401k Plans for Self-Employed Individuals Fact? Or Fiction?; 2008
• "Quick and Dirty Tips"; The Solo 401k; Elizabeth Carlassare; March 2007