Basically, the major difference between a Traditional and Roth IRA is the way Uncle Sam treats the money you invested. If you invest in a traditional IRA you can deduct the contributions from your taxable income within that calendar year. Which means that if you earned $50,000 and you contributed $5000 to your IRA account, you would only pay taxes on $45,000. The $5,000 you contributed during the year has been tax deferred. With a Roth IRA you cannot deduct the contributions you made that year, so using the example above you would of had to pay taxes on $50,000 because your IRA contributions were not tax deferred.
So basically a traditional IRA is the way to go?
Well not exactly, it all depends on your current financial situation....
With the traditional IRA you will eventually have to pay taxes on all accumulated interest, capital gains, and dividends you made from that investment over the years. However, with a Roth IRA you would not have to pay taxes on any capital gains, or interest you made from that investment. So when you turn 59 1/2 (the current age limit you can begin to withdraw your money without incurring a penalty) you will be doing the running man dance all the way to the bank because Uncle Sam can't touched that money.
As for me, I'm currently invested in a traditional IRA because at time I opened up my IRA account I needed a much needed tax break. However, if I had to do it over again I would have invested in a Roth IRA. With all the flexibility, savings power and tax free money a Roth IRA provides, you would be a fool not to make it part of your retirement portfolio.
Basic Guidelines and Benefit for a Roth IRA.
Can contribute up to $4,000 to Roth account. Contribution limit rises to $5,000 in 2008
Unlike a 401k you can place your money in almost any investment vehicle from stocks, bonds, mutual funds, and real estate.
Money is tax free during withdrawal period. Again, that's after age 59 1/2, and your account has been open for at least five years.
You are able to cash out up to 10,000 to buy a new home.You can withdraw funds to help pay your child's college education.
Q: I am trying to decide if opening and contributing to a Roth IRA would be a better option than contributing over and above what my company matches in my 401K.
A: Ideally, it 's best to max out both your 401K and Roth IRA accounts; the more you can save for retirement the better. However, for many people this is not possible, so the question then becomes which account should I invest in first?
Generally, it 's best to invest in your 401K plan first, up to the amount your employer will match, then to invest in a Roth IRA. If you have additional funds to invest after making the maximum contribution to your Roth IRA, you should max out your 401K, and then invest in taxable accounts. There are always exceptions, however, so here are some points to consider when deciding the best order to invest your retirement funds:
Matching Contribution - many employers will provide a matching contribution when you elect to participate in the company 401K or other employer sponsored retirement plan. This is free money, and should be taken advantage of even if your 401K plan isn't the best due to poor investment choices, high expenses, etc. There is no matching contribution for a Roth IRA, so you should invest in your 401K up to the matching contribution first, before you invest in a Roth IRA.
Investment Choices - Most 401K plans have a limited number of investments to choose from. Roth IRAs can be opened just about anywhere: mutual fund companies, brokerage firms, banks, etc., which means your investment choices are unlimited. If your 401K plan has limited or poor investment selections to choose from, the Roth IRA may be the better choice (after you contribute enough to get the matching contribution in your 401K plan).
Taxes - although your 401K contributions are tax-deferred, which allows more of your money to go to work for you, money invested in a Roth IRA grows tax free. As long as you follow the rules, you may never pay taxes on the earnings in a Roth IRA. If you expect to be in a higher tax bracket when you retire, this could result in substantial tax savings.
Because withdrawals from a 401K account are taxed at your ordinary income tax rate, withdrawals could potentially push you into a higher tax bracket. If you have a combination of 401K and Roth IRA accounts, you have greater flexibility in choosing which account to withdraw from, which could allow for tax planning opportunities to help minimize your taxes during your retirement years.
One more note regarding taxes: 401K, traditional IRAs, and other employer sponsored retirement plans are subject to the Required Minimum Distribution rules; Roth IRAs are not. Again, having Roth IRAs in combination with your 401K accounts can provide tax planning opportunities not available to people who only have 401K accounts.
Withdrawals - your contributions to a Roth IRA are available to you penalty and tax-free at any time. Your earnings in a Roth IRA may also be withdrawn at any time. There is a 10% penalty, but this penalty may be waived under certain circumstances (disabled, first time homebuyer, qualified higher education expenses and more). Withdrawals from a 401K plan are much more restricted, as employers may or may not allow early withdrawals or loans.
Automatic investments - contributions to your 401K account are automatic since they come directly from your paycheck. This makes investing in your 401K easy and convenient, and after you've started contributing, most likely you'll no longer miss the money being invested. Investing in a Roth IRA takes more effort. Although many Roth IRA custodians will allow you to setup an automatic investment plan from your checking or savings account, it takes more discipline to invest in a Roth IRA than it does to invest in a 401K plan. If you think you don't have the discipline to invest in a Roth IRA account, then investing in a 401K plan (even a poor 401K plan) is better than not investing at all.
Conclusion: Everyone 's situation is different, and there is no one specific order for retirement investing that is perfect for everyone. However, investing in your 401K up to the matching percentage, and then opening a Roth IRA is a good strategy for most people, as a combination of 401K and Roth IRAs could provide you with the best of both worlds. Both types of accounts have many benefits which can allow for flexibility and planning opportunities when it comes to withdrawals and taxes, both before and after you retire.
With a change in the laws, there never was a better time to start a 401(k) retirement fund. In fact, you may find that you have already started one, because under the new law, your employer can put you into a 401(k) retirement fund automatically.
If that happens – or has happened - to you, you might not pleased at first because some of your salary will be deducted to pay it. But believe me, any investment for your retirement is a good investment – and if you have not started one, do so today. It is that simple.
Other changes in the law are that the Roth 401 (k) is now permanently available. The difference between a Roth and ordinary 401(k) retirement fund is that you invest out of taxed income, but with withdraw tax-free. With a 401(k) retirement fund, you get tax relief on your investment, but get taxed when you start to withdraw from it.
401(k) or Roth 401(k)
Which is best? That depends on your situation, and it is best to discuss this with a financial adviser – but make sure you find a good one. You are likely to do better with a Roth 401 (k) if you are a high earner and will pay a lot of tax on your retirement income – but this may not be the case for you. It depends on your tax payments now and expected future tax payments.
Once you have set up a 401(k) retirement fund, you need to take some interest in it – this will repay you handsomely. Most people just put their money in one fund, and forget it. Then, 30 years later they might find it has not grown as much as they expected.
Review your funds annually
To avoid this happening to you, review your fund or funds every year. If you are unsure how to do it, find a good financial advisor – one who puts your interest first. You need someone who will spell out the fund charges, compare them, and recommend you invest in more than one fund. It is never a good thing to put all your eggs in one basket, and this is very true of investing for retirement. Whether you use a financial advisor or not make sure you do review your 401(k) retirement fund each year. Also remember that if you use a financial advisor he or she gives you a service they will charge for it one way or another, and you need to know how they are charging. It may be coming out of commissions – not a good way – or they may charge you a fee. You do not need a financial advisor if you are happy to keep up to date with mutual funds and investment – it is not so easy to learn.
Disclaimer
The information on this web site does not constitute an offer in any way. It gives general information, but is not financial advice. The aim is to help you decide what to do about your retirement plan, and the importance of saving for retirement. You should consult a retirement planning adviser with a proven record before setting up a retirement plan.
