As we’ve discussed in previous posts, there are many different ways to invest your money (index funds or mutual funds). But that doesn’t encompass the full story or tell you what type of account within that broad category to invest in. The two biggest, well known types of accounts are the 401k and the Roth IRA. The main difference comes in the way they are taxed. With a 401k, the money going in is not taxed, however when you withdraw from the account, it is taxed.
With a Roth IRA, the money going in is taxed, but when you withdraw from the account it is not taxed. While both have its merits, as a person in their 20’s that is starting out investing, which one is for you?
Why I Believe the Roth is Better
Traditional advice says to invest in your company 401k and at least take the match. Why is this important? Because it is free money that the company is contributing to you. However, you then have the choice to continue contributing to your 401k or you could say, I want to open up a Roth IRA. The logic behind this would be that as you are starting out in your work career, your earnings aren’t at a very high level, so your effective tax rate is going to be very low. Because of that, it makes sense to contribute after-tax dollars to a Roth, and watch the investment grow tax-free for years down the road. Because you’re expecting to have a higher income in the years to come, a Roth IRA could be great option for a young investor. In 2006, a new investment account was created; the Roth 401k. It is offered by an employee similar to a traditional 401k, but it gives the tax benefits of the Roth IRA.
To illustrate this example further, look here
As you can see, for the young investor, contributing to a Roth type of investment can have a dramatic difference on your after tax total when it comes time to withdrawing your money. Like many investment choices, it depends on your own personal situation, when you think you’ll need the money, and what your employer offers.
In the comment section below, let me know what your thoughts are on traditional 401k’s vs. the Roth 401k and Roth IRA!