401(k) plans are definitely a good thing. In nearly all cases, taking advantage of your employer’s 401(k) plan is a sensible thing to do — not only for tax management, but also for your long-term financial health. But there are other accounts available that may prove to be even more valuable down the line. Headlining this list is the Roth IRA.
Below, I’ll explain why I’d prioritize a Roth IRA over a 401(k) any day of the week.
Tax-free space is hard to come by
The Roth IRA is known for being one of the few tax-exempt retirement accounts. Once you contribute money, you won’t have to worry about a tax liability later in life — and that applies to both initial contributions and their associated earnings.
The trade-off is that you’ll need to use after-tax dollars to make contributions in the current tax year. You’ll also need to be at least 59 1/2 years of age and the IRA must have been open for at least five years to make tax- and penalty-free withdrawals.
Additionally, tax-free space is hard to find. You’re only allowed to contribute $6,500 to your Roth IRA in 2023 ($7,500 if you’re over 50). Relative to 401(k) plans (limit over $20,000) and taxable brokerage accounts (no limit), IRA contributions are actually quite small. At the same time, IRA space is also unusually valuable, given the tax-exempt nature of the account. From that perspective, prioritizing the Roth over other retirement accounts can make a lot of sense.
You have more investing freedom
Most 401(k) plans come with a pre-selected menu of mutual funds for plan participants to invest in. Some may even come with an option to invest in company stock at a discount, but this varies from employer to employer. Beyond these investment options, you don’t have much control over how your retirement money is invested if you’re working solely with your employer’s 401(k) plan.
With a Roth IRA — which you’ll open on a brokerage platform of your choice — you have the freedom to invest in what you want. This means you can invest in nearly anything, including mutual funds, stocks, bonds, exchange-traded funds (ETFs), and in some cases, cryptocurrency.
For some 401(k) investors, mutual funds may be more than enough. But for a wide section of others, there might be interest in other investment vehicles beyond just standard mutual funds.
It might be cheaper
Some legacy 401(k) plans come with both high administrative fees and expensive mutual fund options. This makes them less than ideal for retirement since you’ll be subject to these additional costs for several decades. What’s more, you’re also subject to the 401(k) provider that your employer chooses — you won’t have any say as to who your company chooses to manage its 401(k) plan.
Roth IRAs are available for free (or perhaps a one-time nominal charge) at several brokers across the internet. Many brokerage platforms also come with no account fees and no trading commissions, so you’ll be able to have some control over your fees right from the get-go. You also have control over your investments to a greater degree, so there’ll be no expensive investments unless you opt for them yourself.
When in doubt, opt for both
This isn’t to say that 401(k)s don’t have benefits. For those in high tax brackets now who expect to have lower tax rates in retirement, 401(k) contributions can be the better bet.
Nevertheless, the benefits of Roth IRAs make it smart to consider holding both a 401(k) and a Roth IRA if you can swing it. And for many, before loading the max into your 401(k) for the year, it can be a great move to contribute as much as you can to a Roth IRA. You’ll benefit from tax-exempt earnings, more investment freedom, and generally lower costs.
No matter what you ultimately decide to do, be sure to give it some thought and consult with a qualified tax advisor or financial planner, if necessary.
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