All this week we are going into detail on each of my four steps to financial freedom.  On Monday we  discussed the strategies for paying off debt and Tuesday we talked about how to start an emergency fund.  Today we get to retirement accounts and will outline the differences between the two main options; a 401(k) and a Roth IRA.

With the future of social security looking more glim every day and the idea of a company pension to support you through retirement all but extinct, it has never been more important to understand retirement accounts and begin investing in them.  Individual retirement accounts, or IRA’s, allow you to invest your income, up to a certain amount, into stocks, bonds and other investments in order to help fund your retirement.  They also usually offer differing tax advantages and penalties for taking the money out before reaching a certain age.

There are many different retirement accounts to choose from, but by far the two most popular are the 401(k) and the Roth IRA.  Before deciding which is best for you, let’s discuss each and their advantages and disadvantages.

401(k)

A 401(k) is an employer sponsored retirement plan that allows employees to take out a portion of money from their paychecks, place it in a retirement account and earn interest.  All contributions are tax-deferred and reduce the employees taxable income by the amount contributed.

A 401k retirement plan must be sponsored by an employer or an organization. The actual work of administration and monitoring of accounts is usually outsourced to independent banks, mutual fund companies, financial service enterprises and more. As soon as an employee gets a paycheck at the end of the month, he can transfer a portion of it to his 401k account. Types of investments available include mutual funds, stocks, bonds and money market instruments.

Advantages of 401(k)

  • Tax-deferred contributions- Allows you to contribute more and also reduce your taxable income.
  • High maximum contribution amount- $16,500 for 2009.
  • Many employers will match contribution up to certain percent- Many employers offer a company match that will equal any contribution you make up to a certain percentage of your income.

Disadvantages of a 401(k)

  • Can be some what difficult to move if you switch jobs- If you switch jobs after starting a 401(k) you will likely want to roll over your account to your new job.  Depending on your job, this could be a little stressful, but definitely not impossible or a deal breaker.
  • Earnings are taxed- Unlike a Roth, you will be taxed on all gains when you pull out your money.
  • Penalties and taxes for early withdraw- Should an emergency arise (beyond your emergency fund) and you are forced to withdraw any amount from your 401(k) before retirement, you could be charged a 10 percent penalty fee and forced to pay taxes on the previously tax-deferred contributions.

Roth IRA

In many ways, a Roth IRA is the exact opposite of the 401(k).  All contributions must be made after taxes, while all gains made are taken out tax free.  There are also income limitations for participating in a Roth IRA ($101,000 for single individuals or $159,000 for married couples in 2008) and a much lower maximum contribution amount ($5,000 for anyone under age 50, $6,000 for anyone over age 50).

Advantages of a Roth IRA

  • All gains are tax free- This could offer you a gigantic tax savings when you withdraw the money in retirement.
  • No fees for certain early withdraws- Unlike with a 401(k), there are certain conditions in which you are allowed to withdraw your savings before retirement with no penalty.
  • Does not have to be employer sponsored- You can set up a Roth and invest in it on your own, independant of any companies.
  • Easy to set up and never have to switch- You can get online and set up a Roth IRA in minutes and never have to worry about rolling it over due to switching jobs.

Disadvantages of a Roth IRA

  • Contributions are taxed- All contributions come after taxes, which means less money to invest and higher taxable incomes than with a 401(k).
  • Low contribution maximum- Can only contribute $5,000 per year ($6,000 if over 50).
  • No company match- Since it is not company sponsored, there is no company match.

So which plan is best for me?

I’m sure you are just about tired of seeing me use this sentence, but as with all the other things we have discussed, it depends entirely on your personal situation. 

You will hear arguments that if you are relatively young, it is better to pay taxes now while your tax rate is presumably lower than it will be later, in which case the Roth is best.  Others will tell you to take advantage of the tax breaks now because you don’t know what the future holds, for you or our tax system.  The advice varies from expert to expert, but it all depends on you. There are a few rules that everyone can follow though.

  1. If you have a company match in your 401(k), always contribute at least enough to get the maximum match.  This is free money.  Free money that you pay no taxes on.  There is no excuse for not taking advantage of it.
  2. If you are maxing out one account, and still have money to invest, begin investing in the other.

The most important thing isn’t which one you choose, it’s that you choose one and start investing in it.  Invest early and invest often.  Invest the maximum your funds (and government limits) will allow you to.  The magic of compounding interest (will discuss in later article) will make your investments increase many times over.

Don’t let the doom and gloom people around you and in the media discourage you from making the best financial decision you can possibly make to fund your retirement.  The current markets make it even more appealing to start investing now.  If you have not yet done so and your debt is paid off with an emergency fund in place, open a retirement account and start contributing.

Tomorrow on Centsability to Wealth we will discuss how to open a Roth IRA.  Please continue sending any questions, tips and story ideas to centsabilitytowealth@gmail.com. 

 

 

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