Wednesday, August 29, 2012

The Difference Between a Roth IRA, a Traditional IRA, and a 401(k) Plan - Part 2

Hello everyone.
Last time, I spoke about what a Roth IRA is and all of the nuances of it regarding contribution limits, withdrawal restrictions, and how it is taxed. Today, we will discuss the traditional IRA and 401(k) plans. Let's dive in.

TRADITIONAL IRA
A traditional IRA is very similar to a Roth IRA in that its purpose is to help middle income Americans save for retirement and provide them with significant tax savings. However, the crucial distinction between a Roth IRA and a traditional IRA is that whereas a Roth IRA is funded with after tax dollars, a traditional IRA is funded with pretax dollars. That is to say, you can write your traditional IRA contribution off on your taxes, thereby lowering your annual income. This allows you take advantage of the power of compounding interest without being taxed until you withdraw your contributions and gains, if any, at 59.5. The chart below shows just how powerful the power of not being taxed is when coupled with the power of compound interest over an extended period of time.

(*Note: The example above assumes a tax bracket of 25%, a weekly investment of $25, an annual wage increase of 3%, and 8% annual investment growth.)
 
Because the money that you contribute to a traditional IRA is pretax money (money that you have never paid income taxes on), you will be taxed on your gains and contributions at the income tax bracket into which you fall at 59.5 - the age when you can withdraw your money without penalty. In contrast to a Roth IRA though, you may not withdraw your contributions at any time. If you withdraw your contributions prior to 59.5, you will be taxed on the withdrawal at your current income tax bracket, in addition to being hit with a 10% penalty on the withdrawal.

For single people who wish to contribute to a traditional IRA, in order to qualify, you must not make more than $58,000. For those who are married and filing jointly, you may not make more than $92,000 if you wish to make a full contribution. Also, just like a Roth IRA, you make only contribute up to $5,000 a year if you are under 50 and $6,000 a year if you are 50 or older. However, unlike a Roth IRA which has no age at which you must begin taking distributions from the account, in a traditional IRA, you must begin taking distributions at age 70.5.

401(K) Plan  
A 401(K) plan - or for those who work for non-profit institutions, a 403(b) plan - is an employer sponsored retirement savings plan where usually an employer matches (puts the same amount of money in for every dollar that you put in) your contributions up to a certain point. Usually this match from the employer goes up to 5 - 6% of your salary. Let's say you make $100,000 a year and are 35 years old. The maximum amount  that an individual under 50 can contribute is $17,000 in 2012 and $22,500 for those 50 or older. Let's say you contribute the maximum of $17,000 per year. Your company will usually match no more than $5,000 to $6,000 a year of your contribution. Because 401(K) plans usually have mediocre investment options, are relatively inflexible, and concentrate all of your wealth in your job, I recommend only contributing just enough to your 401(K) to get the company match. Any left over money that you would like to invest should be socked away into a Roth IRA.

401(K)s are inflexible because if you want to make an early withdrawal, just like the traditional IRA, you cannot withdraw your contributions without being hit with a 10% penalty and federal income taxes. You may however take a loan from your 401(k) plan, provided that you pay it back within 60 to 90 days (the amount of time varies from employer to employer). However, you are paying interest on this loan while it is outstanding. Also, if you quit or lose your job, then the loan becomes immediately payable. Lastly, if hardship withdrawals are allowed in the plan, you may be able to withdraw money to prevent foreclosure/eviction, pay for qualifying educational expenses, and cover any medical expenses not covered by the company insurance plan. However, a 10% withdrawal penalty will still apply to any distribution.

In my next post, I will discuss how to choose investments for each of these vehicles so as to maximize the tax advantage you receive in each. But if you would like a chart view of the distinctions between a 401(K), a Roth IRA, and a traditional IRA, click here. Until next time....

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