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One of the most often asked questions planners get about retirement planning is what is better for retirement planning: a 401(k) or a Roth IRA. The answer may not be as straightforward as it might appear.
WHAT ARE THE OPTIONS?
401(K)
Under section 401(k) of the IRS code, a 401(k) is an employer-sponsored deferred contribution plan for retirement. In your workplace, you set up a 401(k) plan with human resources and select options within the defined plan. Your employer takes money out of your paycheck prior to income taxes being taken out and deposits this in to your 401(k) plan. Some employers even match your contributions. When you retire, you can choose to withdraw money out of the 401(k), but those withdrawals are subject to income tax when they are taken out 10,20, 30 years later. Currently, there's no income limitations on who can contribute, but an individual can contribute at most $15,500 to their 401(k) in 2008. $46,000 is the maximum aggregate amount that can be contributed between employer and worker in 2008.
ROTH IRA
Senator William Roth was the chief sponsor of this movement. A Roth IRA is an individual retirement account independent from your employer that you generate directly with a custodian firm. After a Roth IRA account is set up, these designs have a much wider investment choice usually, and then directly deposit after-tax money from your checking account in to the Roth IRA. Then, after you turn 59 1/2 years elderly and have had the plan for at least three years, you can withdraw from the account entirely tax free. In 2009, the maximum you can contribute is $5,000 a year (unless you are over 50). There is one giant qualification: in case you make over $99,000 individually or $156,000 as a married couple, you cannot contribute the full amount (and may not be able to contribute at all).
401(K) OR ROTH IRA: THE LARGEST DIFFERENCES (PROS & CONS)
The largest differences between the three designs are workplace contributions, investment options/management, and taxes. Let's walk through each feature.
1) Workplace contributions - Employers with a 401(k) retirement plan may or may not match contributions made by an worker. For example, a 401(k) program may offer a 50% match for every dollar the worker contributes to a 401(k) up to 4% of the wage. Therefore, if the worker contributes 4% of their wage to their 401(k), the employer also puts in an additional 2% of your wage, effectively increasing your contribution by 50%. In short, employers that offer matching contributions to your 401(k) ought to be revered. This usually trumps any other consideration regarding the decision to contribute to a 401(k). It is free money, like a year-end bonus that comes every 2 weeks - don't turn it down.
2) Investment options - With a 401(k), you are forced in to whatever management and investment options are offered to you by the plan your employer offers which usually mean the investment choices are restrictive and expensive. Things to watch out for in these investment designs are mutual fund expense ratios and investment options. A Roth IRA is flexible and allows one to select investment options - you even pick the custodian you need to make use of. Roth IRAs offer an advantage with regards to flexibility of investment choices, though if your 401(k) offers solid options, this may not be a great advantage รข€“ but most don't.
3) Taxes - This is the hard one out of the three because it involves a level of prediction of what the future holds for you. In case you think your income tax rate will be higher at the time of withdrawal than it is currently, a Roth IRA is the better option and will save you in the long run.
How can someone expect to know future tax rates? Here are some things to think about:
Will my income grow significantly between now and retirement? In case you think it will, you'll likely be in a higher tax bracket at that time, which favors the Roth. In case you feel that you are near your peak, you'll probably be in the same bracket or lower, which could favor the 401(k).
Do I expect to be working in my retirement years? In case you think that you will, you have a high chance of being in the same tax bracket or higher than you are now. If the answer is no, likely your income will be lower.
Will the political landscape shift towards higher tax rates? It is simple to speculate that with the expected budget deficits, tax rates will go up, and that favors the Roth IRA. In case you think they will decline, that would favor the 401(k).
401(K) OR ROTH IRA: SO WHAT SHOULD I DO?
If your employer offers 401(k) matching, always max it out. This is free money.
The query revolves around what to do with additional retirement money. Given all the above factors, and also assuming you are young and have lots of years of income growth ahead of you, a great option is a Roth IRA.
Finally, there's other tax-free retirement options to think about such as Roth IRA on Roids for slightly more sophisticated investors. It's all the benefits of a Roth IRA with no restrictions and guaranteed principal.
Whichever you choose to pursue, by basically putting money away, you are ahead of the game. Don't let the deliberation keep you from saving - if all else fails, start making contributions immediately to one or the other now and then finalize decisions later - you can always alter your mind in the future.
By: Rashid
WHAT ARE THE OPTIONS?
401(K)
Under section 401(k) of the IRS code, a 401(k) is an employer-sponsored deferred contribution plan for retirement. In your workplace, you set up a 401(k) plan with human resources and select options within the defined plan. Your employer takes money out of your paycheck prior to income taxes being taken out and deposits this in to your 401(k) plan. Some employers even match your contributions. When you retire, you can choose to withdraw money out of the 401(k), but those withdrawals are subject to income tax when they are taken out 10,20, 30 years later. Currently, there's no income limitations on who can contribute, but an individual can contribute at most $15,500 to their 401(k) in 2008. $46,000 is the maximum aggregate amount that can be contributed between employer and worker in 2008.
ROTH IRA
Senator William Roth was the chief sponsor of this movement. A Roth IRA is an individual retirement account independent from your employer that you generate directly with a custodian firm. After a Roth IRA account is set up, these designs have a much wider investment choice usually, and then directly deposit after-tax money from your checking account in to the Roth IRA. Then, after you turn 59 1/2 years elderly and have had the plan for at least three years, you can withdraw from the account entirely tax free. In 2009, the maximum you can contribute is $5,000 a year (unless you are over 50). There is one giant qualification: in case you make over $99,000 individually or $156,000 as a married couple, you cannot contribute the full amount (and may not be able to contribute at all).
401(K) OR ROTH IRA: THE LARGEST DIFFERENCES (PROS & CONS)
The largest differences between the three designs are workplace contributions, investment options/management, and taxes. Let's walk through each feature.
1) Workplace contributions - Employers with a 401(k) retirement plan may or may not match contributions made by an worker. For example, a 401(k) program may offer a 50% match for every dollar the worker contributes to a 401(k) up to 4% of the wage. Therefore, if the worker contributes 4% of their wage to their 401(k), the employer also puts in an additional 2% of your wage, effectively increasing your contribution by 50%. In short, employers that offer matching contributions to your 401(k) ought to be revered. This usually trumps any other consideration regarding the decision to contribute to a 401(k). It is free money, like a year-end bonus that comes every 2 weeks - don't turn it down.
2) Investment options - With a 401(k), you are forced in to whatever management and investment options are offered to you by the plan your employer offers which usually mean the investment choices are restrictive and expensive. Things to watch out for in these investment designs are mutual fund expense ratios and investment options. A Roth IRA is flexible and allows one to select investment options - you even pick the custodian you need to make use of. Roth IRAs offer an advantage with regards to flexibility of investment choices, though if your 401(k) offers solid options, this may not be a great advantage รข€“ but most don't.
3) Taxes - This is the hard one out of the three because it involves a level of prediction of what the future holds for you. In case you think your income tax rate will be higher at the time of withdrawal than it is currently, a Roth IRA is the better option and will save you in the long run.
How can someone expect to know future tax rates? Here are some things to think about:
Will my income grow significantly between now and retirement? In case you think it will, you'll likely be in a higher tax bracket at that time, which favors the Roth. In case you feel that you are near your peak, you'll probably be in the same bracket or lower, which could favor the 401(k).
Do I expect to be working in my retirement years? In case you think that you will, you have a high chance of being in the same tax bracket or higher than you are now. If the answer is no, likely your income will be lower.
Will the political landscape shift towards higher tax rates? It is simple to speculate that with the expected budget deficits, tax rates will go up, and that favors the Roth IRA. In case you think they will decline, that would favor the 401(k).
401(K) OR ROTH IRA: SO WHAT SHOULD I DO?
If your employer offers 401(k) matching, always max it out. This is free money.
The query revolves around what to do with additional retirement money. Given all the above factors, and also assuming you are young and have lots of years of income growth ahead of you, a great option is a Roth IRA.
Finally, there's other tax-free retirement options to think about such as Roth IRA on Roids for slightly more sophisticated investors. It's all the benefits of a Roth IRA with no restrictions and guaranteed principal.
Whichever you choose to pursue, by basically putting money away, you are ahead of the game. Don't let the deliberation keep you from saving - if all else fails, start making contributions immediately to one or the other now and then finalize decisions later - you can always alter your mind in the future.
By: Rashid
