Should I Divert Unmatched 401k Contributions to a Roth IRA?

Note: A participant's first priority should be to contribute enough to their 401k plan to obtain the entire employer match.

In most cases, no. 401k contributions and contributions to a Roth IRA benefit from identical favored tax treatment over the life of the investment. (See examples below.) Since the tax benefits of the two saving schemes are identical, an investor should be indifferent between the two types of saving on tax grounds. Plus, the Roth IRA is capped at $4,000 after-tax, while most 401k participants can invest much more than that before reaching the current 401k cap of $14,000 before-tax.

Since the tax treatments are identical, and the limit on the 401k contributions is much higher, you should continue to make unmatched contributions to your 401k until the maximum is reached. Diverting unmatched 401k contributions to a Roth will not give you additional tax saving, but will increase your transaction costs, and possibly management fees as well.

There may be non-tax reasons to prefer a Roth IRA. Say, for example, that you are not happy with the investments available in your 401k plan. If your asset choices are restricted in your 401k, then since the tax treatments are the same, you may prefer to choose your own investments for the $4,000 after-tax that you are allowed to invest in a Roth.

401k and Roth IRA Contribution Examples

The examples below illustrate that the tax liabilities of comparable 401k and Roth IRA contributions are equivalent. In general, the 401k contribution is made in pre-tax dollars, and while you pay taxes on the value of the account at withdrawal, you are essentially only paying taxes on the contributions – earnings are effectively tax-free. A Roth contribution is made in after-tax dollars – you pay taxes on the contribution up-front, and its earnings are also tax-free. The key to comparing after-tax returns on a 401k investment to a Roth is to be sure that the contributions you are comparing involve the same amount of pre-tax income.
 

To illustrate with a simple example, suppose I face a 30 percent marginal tax rate and I want to save my next $1,000 of salary in either my 401k plan or a Roth. If I invest in the 401k plan, since the contribution is not taxed (it’s deducted from your paycheck before taxes), I put the entire $1,000 into the account. Contributions to a Roth are made after-tax, however, so if I receive the $1,000 as salary today, I can contribute only $700 ($1,000-$300tax) to a Roth.

Ignoring penalties, suppose I want to withdraw from the accounts the following year. My tax rate is still 30 percent and the pre-tax interest rate is five percent. I withdraw $735 ($700x1.05) from the Roth and pay no additional taxes. Or, I withdraw $1050 ($1000x1.05) from my 401k, pay my 30 percent tax of $315 ($1050x.3), and have $735 left. The tax liabilities of the Roth and the 401k plan are identical. This is true for an investment of any time horizon.

I make these comparisons assuming that my tax rate today is the same as the tax rate I face when I withdraw the funds. If my tax rate were lower in the future (due to lower retirement income, for example) then the 401k plan would have a higher after-tax return than the Roth. But if my tax bracket increases after retirement, then the 401k plan would have a lower after-tax return than the Roth IRA. Changes in my future tax rate will not affect the after-tax return from the Roth, since taxes are paid before the contribution. The Roth would still return $735 in the example above. But, if my tax rate is 20 percent at withdrawal, when I withdraw the $1050 from my 401k plan, I pay $210 ($1050x.2) in taxes and have $840 left. When my tax rate is lower at withdrawal, the 401k plan beats the Roth. But, if my tax rate at withdrawal is 40 percent, when I withdraw the $1050 from the 401k plan, I pay $420 in taxes, and have $630 left over. When my tax rate is higher at withdrawal, the Roth after-tax returns are higher than those from my 401k plan.

A comparison between a 401k contribution and a Roth IRA contribution may also be framed in terms of a $1,000 after-tax contribution to a Roth. Suppose I want to compare an investment of $1,000 in a Roth to the equivalent investment in my 401k plan. The right question to ask is: How much pre-tax income would I need to make the $1,000 Roth contribution? That is the amount I could invest in my 401k instead. Since Roth contributions are made after-tax, I need $1,430 in income ($1,000=$1,430x(1-.3)) to contribute $1,000 to a Roth. The after-tax $1,000 contribution to the Roth grows to $1050 next year with no additional liability. If, instead, I save the $1,430 in the 401k plan, it grows to $1,500 ($1,430x1.05) in one year, leaving $1,050 ($1,500x(1-.3)) after-tax.

And the Winner is....

No matter how you argue it, from the point of view of tax liability, the 401k plan without matching and the Roth IRA are equivalent forms of saving. Of course, if you can afford to save more after you have maximized your 401k contributions, you might invest an additional $4,000 after-tax in a Roth IRA. Some investors may also be eligible for a conventional IRA. The conventional IRA is capped at $4,000 before- tax, so if you’re going to invest up to $4,000 before taxes, the two IRAs are equivalent (assuming that you are eligible for both). If you can afford the larger investment of $4,000 after-tax, then you should invest in the Roth IRA.
 

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