To 401(k) or to Roth

Question of the week:Citing a need to cut expenses, my employer just suspended its match on employees' 401(k) contributions. With the match gone, I'm wondering if it's better to just set up a Roth IRA and drop the 401(k). What do you think? --Martin S.

Dear Martin,

This is one of those classic dilemmas in which you're forced to compare apples to oranges, which takes a bit of mental juggling. And it's one that more and more people are facing, given that many employers are cutting and even removing their 401(k) matches. The Profit Sharing/401k Council of America says that company contributions in 2001 were an average of 2.5 percent of pay, down from 3.3 percent in 1999.

We recently posed your question to members of the Armchair Millionaire community. Since contributions to 401(k)s are usually tax-deductible and contributions to Roth IRAs are not, much of what we heard was about taxes. Here are comments from both sides:

Go for the Roth. "I have never seen taxes go down over time, so I prefer the Roth IRA. Also I don't want to have to guess what I'll really have left over after taxes when I retire." --Brad

Go for the 401(k). "I fund my 401(k) over a Roth to get the tax deduction now. The current law says that withdrawals on Roth IRAs are not taxable, but who knows what will happen in the future? I don't have enough faith in Congress to trust that they won't someday repeal the Roth IRA, so for now, give me the current deduction." --Bryan J.

In my opinion, if your employer does offer a match on your 401(k), you should go for it. The free money in the form of that match makes the decision a slam dunk.

But if you don't have the match, then you need to have to have a clear understanding of the ups and downs of both kinds of plans. Both offer advantages and disadvantages that, depending on your personal situation, can make a big difference to your retirement. My guide breaks down the major differences between the two.

The Armchair Millionaire Guide to the 401(k)-Roth IRA Debate

• Taxes. A 401(k) contribution is deducted from your income before you pay taxes. Since it reduces your taxable income, it lowers your taxes. However, later--in retirement--you will have to pay tax on the money you withdraw, just like it was ordinary income. For the Roth, you get no tax break now--but you'll never have to pay tax on any of your withdrawals. So it's a matter of choosing whether you pay taxes now, or pay later.
• Contributions. The 401(k) wins here. In 2003, most employees can contribute up to $12,000 per year, and people over the age of 50 can contribute $14,000. The Roth? Just a paltry $3,000 in 2003 (or $3,500 if you're over 50).
• Investment choices. Typically, you'll have a dozen or so choices of mutual funds to invest in with a 401(k) plan. For a Roth IRA, though, the sky's the limit--stocks, bonds, and mutual funds can all be purchased through IRA accounts.
• Convenience. For making investing painless, the 401(k) is hard to beat--the money is taken out of your paycheck before you even see it and invested for you by your employer. For the Roth, you need to save the money, set up your account, and then make the investment. Most IRAs do allow automatic investments, though, so once your IRA is set up you can have regular monthly amounts taken from your checking account and invested in your IRA.
• Withdrawals. Uncle Sam says that you have to start withdrawing your money from your 401(k) by the time you hit age 701/2, and that you have to take out a minimum specified amount each year after that. On the other hand, you don't ever have to make withdrawals from your Roth IRA if you don't want to, making it a valuable estate planning tool.

THE BOTTOM LINE: Like every other investing decision, choosing a 401(k) or a Roth IRA requires you to look at a range of issues, most of them not black and white. Weigh each issue carefully to arrive at the best option. And if you're still not sure, then get the best of both worlds--fund both your 401(k) and a Roth IRA!