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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 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 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?

Author Bio

Total Articles: 1081
Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Article comments

Allen Taylor says:

I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you.

Allen Taylor

CiaranFromChance says:

Great post Dough.

To take it a step further, I’d say opening and funding a Roth is always the right decision, regardless of where taxes (or your personal tax rate) will be in the future.

This is predicated on a few things: age, risk tolerance and commitment. For example…

If you’re 36 years old, are a moderate to growth oriented investor (which most should be comfortable being)and have decided to make your Roth contributions a yearly life priority, then you will no doubt have made the right decision for your future.

Perfect world scenario, having a 401(k) with a match and a maxed out Roth contribution each year.

Assumptions here: little to no debt:)

Randall says:

My case may be a bit unusual. I have a LOT of credit card debt, but everything is below 9% (with a majority at 0%). Because of this and the wonderful Compound Interest principle. I always fund everything before paying bills. It keeps my balances on CCs high, but from an overall standpoint, I make more money on the investments than I spend on debt maintenance. Kind of a non-arbitrage arbitrage.

Best Advice on Debt says:

I personally subscribe to the Dave Ramsey school of thought. Get rid of your debt first (except for your house), build an emergency fund, and then start investing.

It’s helped me & thousands others become truley wealthy. So it’s the one I recommend. However, that’s not saying there are other ways.

Shane says:

Responding to CiaranFromChance – although Roth IRA’s may be valuable to some, I’d argue that they really aren’t for everybody. The largest incentive for a Roth IRA is locking in your tax bracket now, with the idea that your accumulated wealth is tax-free in the future. One must bear in mind, however, that it’s very likely once retired your tax bracket will be lower, and (more importantly) seniors have much more play in playing with their taxable income.

A second thought one must consider is the simple element of compounding – starting with more (i.e. – before tax contributions) will build that snowball quite a bit faster than after-tax contributions (which, naturally are lower) .. One must have a long time horizon and assume higher tax brackets in retirement for it to be a financially cost-effective decision.

Lily says:

I agree with Shane. One also must assume that the government will keep Roth tax-free in the future. Without getting into politics, that’s not guaranteed (after all, people used to think SS benefits would never be taxed).

The Federal Reserves estimates that the return consumers get by paying off credit cards is a whopping 14.4%.

I would suggest paying them off and then using the payment amounts to fund a Roth IRA. But that’s just me 🙂

Jon says:

One concern I have is all the talk about a national sales tax. If that is used to replace (entirely or in part) the income tax, Roth IRA investors will be seriously harmed. I’m thinking that from now on I should split investments between Roth and Traditional IRAs.

Dough, I’d love to see an article about retirement savings for people who have no access to 401(k) plans. What options are there to save more than the IRA limit? Can you start a 401(k) for yourself?

Connie says:

@ Jon, I think splitting the difference between both types of IRAs is a nice insurance policy.

I do not have a 401(k) option through my employer, so I instead split that money between a high interest savings account (keeping it more liquid) and a regular stock account.

It’s not ideal by any means, I would also be really interested in hearing any advice Dough has!

Hal says:

Interesting article. Important thought comes to mind is Pay yourself first. Pay off any debt that is not tax deductible. If your not money management capable, get with a reputable financial advisor to help set up a successful program.

DR says:

Hal, excellent advice. It can be difficult at first, but once you develop the habit of regular savings, it gets much easier.

Charles says:


To the extent that you have taxable income from a business, you should consider an individual 401K. You can contribute the same $15,500 or $20,500 (based on age) as a corporate 401k plus a profit-sharing contribution from your business – all pre-tax if you wish. The only catch is that you have to be a solo employee in your business (your spouse can be an employee also.) All the major brokerage firms have them. If you wish to invest in alternative investments such as real estate, gold or businesses, you need to open a self-directed 401k available at certain trust companies (this what I have.)

I’m not sure how much money we’ve got to work with here, but I would recommend a combination of events: First, concentrate a high proportion of your money to paying down the credit cards. It is unlikely that your investments will ever be more than the interest you are paying on this debt. From there, decide how much you can invest in the 401k. The goal will be to invest enough to get the full employer match. After that, invest anything left over into your Roth IRA. If you ever reach a point where you max-out your Roth, go back to your 401k and start maxing that out as well. This will level out your tax-sheltered plans.

Although there are still student loans to deal with, they will likely be at lower rates than what you could earn “long-term” with your retirement investments. Keep paying them and even add to the principal if you’d like to see them go sooner. But don’t neglect your 401k and Roth first.

Rachel says:

What do I do if the Simple IRA my employee offers has a 5.75% load but 3 % matching of my annual salary? And I have a Roth IRA.

Rob Berger says:

Wow, that’s a tough one. The first thing I’d do is ask your employer to add low cost investing options. I’d also double check to make sure there are some investing alternatives without the load. Still, the match probably makes it worth the cost of the investment. Do you have to make a contribution to get the 3% from your employer?