• Sagar Agarwal

Which of the two retirement plans, 401k vs Roth, to invest in?

Updated: Mar 9

Would you rather prioritize investing in 401k or Roth?

I have been puzzled about which of the two retirement plans should I invest for my retirement? Roth or 401k?

In a 401k plan, your contributions are pre-tax hence you save on tax in the year on investing but you have to pay taxes on gains.

Whereas, in Roth IRA your contributions are post-tax but your investment income is not taxed. One major benefit of investing in Roth IRA is that you can invest in a broader range of investment choices such as futures, derivatives, alternative assets, etc. More on this here

A general view of financial 'gurus' claim is that if you are young (low tax bracket) then invest in Roth IRA, and as you get older (high tax bracket) invest in 401k. This is claimed because when you are young, you don't have to pay a lot of taxes upfront to invest in Roth and you would be able to encash the compounding effect of money with many years ahead of you to retire. Where as, as you get older your taxes are high and by investing in 401k, you save taxes upfront and pay taxes on gains later.

Testing this hypothesis

Statements made by financial gurus are baseless to me without any data supporting this argument. Let us test this theory out and see if it does really make a difference or not. Here are my assumptions:

  1. I have $5,000 to invest a year. I can choose to invest them in 401k, Roth, or a trading account

  2. 401k and Roth give similar returns of 7.5%

  3. The initial tax bracket is 25% and it grows by 1% a year

  4. The investment period is 20 years

The plot below shows the contribution of $5,000 that you would invest in each year after 20 years. As expected the $5,000 that you'd invest in year 1 would contribute more to your networth than what you would invest in years later. This is because there is more time for the investment made in year 1 to grow than that invested in later years.

Something that is surprising to me is that Roth doesn't give me as much benefit as a traditional 401k even in the initial years. This suggests that it doesn't matter (by much) if you rather invest in 401k or Roth.

But some might argue and think, 'but Sagar, I can invest in other assets in Roth which I cant in 401k. You have not done an apples-to-apples comparison.' True, this is not a perfect comparison but it's pretty close. I don't think active management can give higher returns but still let us look at the premium you need to earn to justify Roth over 401k.

Premium to earn in Roth to be able to justify Roth over 401k

While I am agreeing that Roth is better to invest in for the first 2-3 years of 20 year career. I wanted to find why should one ever prioritize Roth over 401k. I compare networth of two investors earning different returns in the two retirement plans. Below is the table of the difference of networth of the investor investing in Roth and investing in 401k. A negative would mean that 401k investor outperforms Roth investor.

I see that the returns that investor in Roth needs to get returns around 2%- 2.5% higher 'consistently' to get a higher networth that 401k investor. Trust me this is a huge number! A 2-2.5% return outperformance is something 95% of active investors are not able to achieve. It is a mere stroke of luck if you have outperformed passive investors in 2020. But to do this for 20 years would make you a remarkable investor.

The ugly truth of investing via Robinhood/WeBull

Finally, in my view, investing via retail trading platforms ONLY makes sense if you are investing money that you would need before retirement. Other than that money for retirement should only go into these platforms after maxing out Roth and 401k.

~$122,919 of your retirement networth is lost when you invest $6,000 in trading app vs in Roth. This money is paid in taxes to government.

At retirement, your networth would be $122,919 more if you invest $6000 in Roth vs if invest the same money in a trading account. This is literally free money that you have left in the table and paid to the government. What these apps offer is ease of trade, great UI and a 'cool' millennial feel. Give me the money. For me, ease of trading <<< more money. A nice UI of Robinhood, a common trading app, doesn't motivate me enough to give away that much money to the government in taxes.

Take aways

I would like to summarize the above analysis into actionable steps for you all. My plan for the above assumptions would be as follows:

  1. First, invest in 401k to max out your company match. This is free money that company gives you. Take that cash.

  2. Prioritize invest in Roth for my first couple of years (2-3 years). Anything after maxing Roth contribution goes into 401k. Above it goes into trading app.

  3. After 2-3 years strat prioritizing 401k. Anything after maxing it, goes into Roth.

  4. After I max both Roth and 401k, then invest via trading apps.

I'd recommend that you should aim to max out your retirement plans as soon as you can to have a secure retirement. Let me know what do you think? Which of the two do you invest in and why?


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