While the traditional 401(k) has many benefits, the Roth IRA is an even more advantageous account to prioritize instead. The idea of never having to pay taxes again is incredibly attractive when compared to a tax-heavy account like a 401(k). What's more, you can open a Roth IRA at a provider of your choice -- without any connection to your current employer.
Here, we'll go through why the Roth IRA should be seen as a priority investment account over the 401(k).
The Roth IRA is (usually) tax-free forever
When you invest money into a 401(k) via automatic payroll contributions, you get a tax deduction in the current year. With Roth IRA contributions, the opposite is true: you voluntarily pay tax at your current rate and contribute money that's already been taxed. In exchange for a tax bill today, you receive the golden opportunity to invest money tax-free forever (so long as you hold your Roth IRA open for five years). This is a gift, both monetarily and psychologically, for most everyday investors.
There's also a bit more flexibility around contributions in a Roth IRA as compared to a 401(k). Once you contribute to a 401(k), you can't take out the money without penalty until age 59.5 without either facing a special hardship or opting for a costly 401(k) loan. Roth IRA contributions, on the other hand, can be withdrawn at any time, both tax- and penalty-free (though you will get hit with taxes and penalties on the earnings portion of any early withdrawal).
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More investing flexibility in a Roth
Unlike a 401(k), a Roth IRA offers the opportunity to invest in whatever you want, including stocks, bonds, options, and in some cases, even cryptocurrency. Most 401(k) plans come with a list of pre-determined mutual funds that you'll need to choose from when you set your asset allocation. Roth IRAs, on the other hand, allow you greater access to the investment universe and more flexibility in choice.
Roth IRAs also don't have Required Minimum Distributions (RMDs); you'll never be told that you need to take money out of your Roth IRA. Recall that 401(k)s -- notably, the "traditional" variety -- come with potentially costly RMDs that can drive up your total tax bill in retirement. In that regard, Roth IRAs can have an indefinite life and even make for a valuable estate planning tool.
You get some extra time to make contributions
Somewhat inconveniently, you can only make contributions to your 401(k) during the tax year, which runs from Jan. 1 through Dec. 31. Roth IRAs operate a bit differently: You can make contributions for one year through tax day of the following year. In other words, you can still contribute to your Roth IRA for 2022 through mid-April 2023. This allows most small investors some extra runway in the event they don't max out their IRA before the calendar comes to a close.
Anyone can have a Roth IRA
Unlike a 401(k), you don't necessarily have to be employed to open a Roth IRA. You also can still get money into a Roth IRA even if you have income that exceeds the annual limits for a direct contribution. This is done through a backdoor Roth IRA contribution.
With a backdoor Roth IRA contribution, you first contribute money to a traditional IRA and then convert the balance to a Roth IRA. This is a clever way to make use of valuable tax-exempt space even if you earn too much to contribute directly to a Roth. Importantly, the backdoor Roth will only work if you don't have any existing traditional IRA balance -- otherwise, you'll be setting yourself up for a tax headache.
Consider maintaining both accounts
While the Roth IRA does have the 401(k) beat on a number of different dimensions, the 401(k) can serve an effective complementary role -- especially if your employer offers a matching contribution. A 401(k) can also come in handy if you find yourself earning large amounts of money early in life and want to defer taxes on some of it. For these reasons, 401(k)s often play a part for those seeking financial independence.
Overall, the Roth IRA takes tax management out of the equation for the rest of your life -- an especially valuable attribute if you have a complicated financial situation, to begin with. With low contribution limits, it's a no-brainer to max out your Roth IRA to the extent possible. For best results, or if you're unsure, don't be afraid to reach out to a qualified financial planner for help.
