Tuesday, August 28, 2012

The Difference Between a Roth IRA, a Traditional IRA, and a 401(k) Plan - Part 1

Hey everybody.
Today I'll be discussing the difference between a Roth IRA, a traditional IRA, and a 401(k) plan. But before I get into the nuanced differences between the things listed above, let me briefly discuss the one thing all of the above have in common - a Roth IRA, a traditional IRA, and a 401(k) plan are all investment vehicles and not investments themselves. They are not something that you invest in. Rather, they are a place for you to park your money, like a checking or a savings account, but within each you can choose to invest in either stocks, bonds, mutual funds, and ETFs (exchange traded funds). The flexibility of the investment options within each investment vehicle and the restrictions on when withdrawals can be made and how such withdrawals are made is where the distinctions come in. So now that we know the overarching similarity between the accounts, let's dive into what each one is.

ROTH IRA
A Roth IRA is a great investment vehicle and is the most flexible of all of the accounts. It was created by Senator William Roth of Delaware back in 1997. Its purpose is to provide a tax advantaged account in which middle income Americans can save for retirement. This is how it works. In order to be eligible to fully contribute to it, if you are single, you cannot  make more than $110,000 a year. If you are married and file taxes jointly with your spouse, you cannot fully contribute to it if you make more than $173,000 combined.

The maximum contribution that may be made to a Roth IRA by any individual who qualifies is $5,000 per year. (Note that as the cost of living rises, Congress and the Internal Revenue Service raise the amount that can be contributed every few years.)  Individuals who are eligible to contribute and are 50 yrs. of age or older may contribute $6,000, instead of the $5,000 that everyone else is limited to, in the 2012 tax year. This is because people in their 50s are closer to retirement than the rest of us and the government wants to encourage them to sock away more money.

As I said before, there are many advantages to the Roth IRA, so let me elaborate on them. The first is that a Roth IRA is funded with after-tax dollars, which means that if you withdraw the money at 59.5 yrs. of age, all of the gains that you have accrued will not be taxed. I repeat, if you withdraw the contributions to and the gains accrued in your Roth IRA at 59.5, you will NEVER have to pay gains on that money! The downside to the Roth IRA is that because it's a retirement account and has such great tax savings, you cannot withdraw all of your gains and contributions before 59.5 without penalty. The penalty to withdrawing your money early and not having such withdrawal fall into a qualifying exception is that you will be taxed at your normal federal income tax rate on your gains, in addition to a penalty of 10% on the amount of the withdrawal.

On the flip side of things though, you can always withdraw however much money you contribute to your Roth IRA without penalty and without ever having to pay it back. You may not, however, withdraw your gains without penalty at any time. Here's an example of what I mean: Let's say you have contributed $5,000 a year to your Roth IRA for 3 years and over the course of that 3 years, your total $15,000 contribution has grown to $20,000. You are entitled to withdraw up to $15,000 without penalty, but you must leave the remaining $5,000 you have earned there until 59.5 or else you will be taxed.

On top of all of this, there are a few loopholes where you actually can withdraw contributions and gains without being penalized. Anyone who holds a Roth IRA is entitled to withdraw up to $10,000 (contributions and gains) in order to make a down payment on a first home. However, the Roth IRA holder must not have owned a home in the previous 24 months and must have held the Roth IRA for at least 5 years.

Lastly, you can invest in any type of security under the sun in a Roth IRA. This means stocks, mutual funds, bonds, stock options, index funds, and ETFs.

In sum, a Roth IRA is a great option for almost everyone, but especially for those who think they will be in a higher tax bracket as they near retirement age. This is because the money that you put into a Roth IRA, will never be taxed, provided you adhere to the restrictions regarding when you can withdraw money. In Part 2, we will discuss what a traditional IRA and a 401(k) plan are and how they are different from one another and from a Roth IRA.
 

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