If you have to choose between contributing to a 401K or a Roth IRA, then the clear answer is pick the 401k especially if the company is matching (around 3-8%) your contribution. In essense, your contribution for the current year just made a 100% rate of return. Moreover, you can save up to $15,000 per year and the contributions are taken before you pay taxes (meaning that they are tax deductible). However, if you still have money leftover, you should consider contributing to a Roth IRA.
Although anybody can open and benefit from a Roth IRA, the ones that would most benefit on this retirement vehicle, in my opinion, are people who are in their late teens or early twenties as this will provide them a huge head start on their retirement goals. Most individuals at this age bracket are still in school and are probably working menial jobs such as working in restaurants, delivery companies, or schools that don’t offer 401k retirement for part-time employees. An individual, sixteen years of age, can contribute only $4,000 per year in the next eight years and still get a very good nest egg come retirement time. See my post Saving For Retirement: The Earlier The Better for a clear explanation of how much the potential earnings would be.
The distributions on the Roth are not taxable – The IRS does not want you to enjoy the double tax benefit. It’s either you get taxed now, or you get taxed later. On a traditional IRA (or 401k, SEP, Keogh, 457, 403b, etc) your contributions are made before your income are taxed. Meaning, your taxable income is reduced by your contributions, thus reducing the taxes that you have to pay come April 15. However, when you retire, the distributions will be taxed. Since all retirement plans allow tax deferred earnings, most people will build a large nest egg. Because of this, these people will be in a higher tax bracket and potentially pay the maximum tax. This would be the disadvantage for people with a retirement plans that allows them to deduct the contributions initially.
With a Roth, you don’t get to reduce your current taxable income when you make your contributions- your contributions are made after your tax salaries. However, the big advantage is that you don’t have to pay taxes when you start cashing out on your savings come retirement time. This is sometimes called “backloaded IRA” because the tax benefits come at the end, not at the beginning.
When it comes to where to invest, an IRA is more flexible than a 401k – meaning that you can invest your money in any way you want. A 401k is limited to investing in stocks and mutual funds. While in an IRA, you can invest in real estate, stocks, mutual funds, bonds, start-up companies, restaurants, and even cows or horses!!
You can withdraw from your Roth to buy your first home – The IRS allows you to take as much as $10,000 per person ($20,000 for married couple) that you can use towards the purchase of your first home without incurring any penalty. You normally get a 10% penalty and the withdrawals are also taxed at your current tax rate if you cash out your Roth IRA ,for reasons not exempt by the IRS, before reaching the age of 59 1/2. For you to take advantage of this rule, the IRA must have been opened at least five years. If you opened your IRA in 2002, and you are planning to purchase your first home this year, then you can tap at most $10,000 towards closing cost or downpayment. But what if you don’t have the five years yet, then your withdrawals will be taxed at your current tax rate. However, you won’t incur the 10% penalty.
Other Roth IRA Tidbits
1.) The maximum contribution in 2007 is $4,000 per person. However, if you are 50 years or older, the maximum is increased to $5,000 (catch-up rule).
2.) Your contributions are reduced (phased-out) if you make a certain amount of money and whether you are covered my a retirement plan at work. For example, for 2007, if you’re married and covered by a retirement plan at work, your maximum contribution is reduced if your modified adjusted gross income (AGI) is more than $83,000 but not less than $103,000 (between $52,000 and $62,000 for single filers or head of household). See publication 590 for more information on the phase out rule.
3.) If you take money out before the 59 1/2 minimum age, your distributions will not be taxable with the following conditions:
a.) It is made after the 5-year periodÂ starting with the first taxable year for which a contribution was made to a Roth IRA and
b.) And the payment or distribution is:
-Made because you are disabled
-Made to a benificiary or your estate after your death
-Made to pay up to $10,000 (lifetime limit) of certain qualified first time buyer amounts.
4.) If you contribute more than your allowable amount for the year, then a 6% excise tax applies to any excess contributions to your IRA.
5.) You can contribute up to April 15 of the next year for the current year’s Roth IRA. For example, most taxpayers’s are on the calendar year tax year, which means that the last day for all income or expenses must be incurred by the end of December 31. If you’re tax year is 2006 and you still have not contributed anything for your Roth IRA, you have until April 15, 2007 to still contribute.