Reader question: Should you invest in a 401(k), a Roth IRA, or pay off credit card debt?

Recently a reader e-mailed me with the following question:

I definitely do want to open a Roth IRA as soon as possible because I hear it's typically better than the Traditional IRA. However, I'm not certain whether one should be putting money way in one's 401K or Roth. As you can tell, I'm not that financially knowledgeable. I do have some credit card debt that shouldn't take too long to pay off and of course I have some student loans. I'm guessing you're recommending me to pay off my credit card debt first before opening a Roth IRA. My student loans on the other hand will take a while to pay off.

I receive questions like this a lot, and so today we'll walk through an approach you can use to answer these questions for yourself.

Save versus pay off debt--it doesn't really matter

If you are living below your means and either saving the difference or using the excess cash to pay off credit cards, you’re moving in the right direction. Certainly you can base your decision by comparing the interest rate on the credit cards and the returns you believe you’ll earn on your investments.

If the interest rate on the credit card is higher than the returns you’re likely to earn on the investments, the math would tell you to pay off the debt first. Fine. But the reality is that if you consistently live below your means, in the long run it probably won’t matter in which order you invest or pay off debt. If your debt is at a very high-interest rate, however, paying it off first is probably best.

Also, the decision is not all or nothing. You can split your excess cash between savings and paying off debt. That's what I did when I was clawing my way out of credit card debt. And if you have a lot of debt that will take years to pay off, I believe waiting that long to save for emergencies and retirement generally is a mistake. Even if you save just a little, developing the habit of saving and investing is too important in my opinion to be put on hold for very long.

Does your employer match 401(k) contributions?

Whether your employer matches contributions is important both to the question of investing versus debt reduction and investing in a 401(k) versus Roth IRA. If there is a match, failing to take advantage of it is leaving free money on the table. Of course, there could be situations where your finances are in such dire shape that contributing to a 401(k) is impossible. But apart from extreme situations, an employer match is a significant incentive to contribute enough to a 401(k) plan to take advantage of the match.

Investing in a 401(k) versus Roth IRA

There are a number of factors to consider here:

• Does your income qualify you to invest in a Roth IRA? In 2012, a married couple filing a joint return can invest in a Roth IRA if their modified AGI is less than $183,000 (although the amount they can invest begins to decline at $173,000). We'll assume that you can invest in a Roth IRA (if you want to open a Roth IRA< check out our list of the best brokers for IRA accounts).
• Does your employer match 401(k) contributions? As mentioned above, if your employer does match contributions, the 401(k) is probably the best bet. We'll assume going forward that your employer does not match your contributions
• How old are you? This may seem like an odd question, but here's why it's important. If you are in your 20s or 30s, you likely are in a relatively low tax bracket. Therefore, paying taxes on your Roth contributions today is likely to be more profitable than waiting to pay the taxes in retirement. In fact, if you use one of the many calculators to determine which is better (here's one), you'll find that they almost always favor the Roth, particularly if you are in a low tax bracket.
• What will you do with the tax savings if you invest in a traditional retirement account? Because traditional 401(k) contributions are excluded from income tax, you'll have more take-home pay than if you invest in either a Roth 401(k) or a Roth IRA. If you invest that savings, then the choice between a Roth and traditional savings vehicle is generally a close call (although I still am partial to Roth accounts). But if you don't invest that savings, the Roth is a clear winner.
• What are your investment options in your 401(k)? Unfortunately, many 401(k)s don’t offer great investment choices. That’s the situation I have at my job. We have a couple of hundred options and, with the exception of a couple of funds, they are all bad. Most of them have expense ratios of more than 1%. With a Roth IRA, you can choose where to open the account and invest in just about anything.
• When will you need the money? When and under what circumstances you can take money out differs between a 401(k) and an IRA. What your loved ones can do with the dough if you pass away is also different. These might not be major considerations for you, but if they are, I can recommend two books: Retire Secure!: Pay Taxes Later - The Key to Making Your Money Last, 2nd Edition. I have this book, and it is very informative.
• How much do you have to invest? The contribution limits are higher for a 401(k) than for a Roth IRA. Of course, you could always max out the Roth IRA and invest in a 401(k).

One final thought: consider tax diversification

The fact is we don't know what tax rates will be a year from now, let alone when we retire. So keep in mind that you can invest in both a traditional 401(k) and a Roth IRA retirement account (assuming your income doesn't disqualify you). And if your employer offers a Roth 401(k), there is no disqualification based on your income. This is the approach I plan to take now that my employer offers a Roth 401(k).

Are there other factors you consider in making these decisions?