In my previous post, I encouraged anyone without a retirement account to start one as a New Year’s resolution. Today I am going to go over some of the basic differences between the types of accounts in a simple and straightforward manner.
There are two basic retirement vehicles, the 401(k) and the IRA. Each of these vehicles takes several forms, i.e. 401(k), 403(b), Roth 401(k), Traditional IRA, Roth IRA, SEP, Self Directed IRA. I will briefly touch on most of these at one point or another during this discussion, but I am going to focus on the forms that are relevant to the most people.
A 401(k) (403(b) is the gov’t employee equivalent) is a retirement vehicle offered by your employer. It is also referred to as a deferred compensation plan. Instead of paying taxes on the money you earn, it is put directly into a retirement account for you. When you withdraw the money in retirement, it will be taxed at whatever the tax rate is for your bracket.
A traditional IRA is somewhat similar, although you initially pay taxes on the money when it is earned, you can claim it as a tax deduction in the same year. You are then taxed when you make withdrawals from the account in retirement.
With either a 401(k) or a traditional IRA, you don’t pay tax on your money as it grows…you pay when you take the money out.
A Roth IRA (this info basically applies to a Roth 401(k) as well) is different from either of the above vehicles because you pay tax on the income when it is earned. The money then grows tax free in the account, and you pay no tax when you take it out.
So which one is right for you? That depends on several factors. Before a 401(k) can even be considered as an option, you need an employer that offers it as an option. Many employers do.
The next consideration should be whether you employer offers a “match.” This has become somewhat less common, but some employers still offer 100% matches of 5-6%. Others offer a 3% match of 100% and then the next 3% at a 50% match. This means that if you are willing to put 3% of your salary, say $1,800, then your employer would match that contribution to your retirement account. So instead of putting $1,800 away in a year, you’d be putting away $3,600. This is a great way to build up your retirement savings. If your employer offers a match, it makes good sense to take advantage of it. There aren’t many (if any) sustainable investments that offer a risk free, guaranteed 100% or even 50% return. When you take advantage of the match, you get that 100% return.
To me, the match is a no brainer. It wouldn’t be good business to pass up those returns. If you have more money to invest after that, you have some options.
You could put even more into your 401(k). Deferred compensation is a good deal. Most of you are probably familiar with the time value of money. The basic principle of the time value of money is this; a dollar received today is worth more than a dollar received tomorrow. The inverse is also true, a dollar paid today is worth more than a dollar paid tomorrow. This is because you could take that money and invest it in the time period between now and when it has to be paid. For example, if you can put off payment of $100 that is owed (at a theoretical 0% interest) for one year, that $100 dollars could be invested at, say, 5%. At the end of the year you still owe $100 dollars, but now you have $105.
There’s a variable that could come into play in just investing all your money in your 401(k) though. That variable is the income tax rate. When you invest your money in a 401(k), as we’ve stated, you are taxed when you withdraw the money. The income tax is subject to political forces beyond your control. Taxes could go up or down in the future, and there’s really no way to know for sure which way they will go. Your income could fluctuate as well. As a rule, it’s intelligent to pay your taxes when your income will be at its lowest point. If you believe you will make less money in the future, and thus have less taxable income, it would be better to put off paying your taxes until that time. If you believe you will make more in the future, it would be smarter to go ahead and pay taxes on the money now. If you believe you’ll make more in the future, the Roth IRA might be the perfect vehicle for you.
As was stated above, a Roth IRA allows you to pay your taxes up front, then grow your money tax free. When you decide to take your money out in accordance with the rules (age 59 1/2 or older), you’ll pay no taxes. This is a valuable hedge against the uncertain future. If you have both a 401(k) or its equivalent, and a Roth, you have tax diversity. If taxes go up, your Roth is well positioned. If they go down, then that’s good for the 401(k) holder.
It’s noteworthy to mention the contribution limits for the respective accounts. If you are 49 or younger in 2009 you can put up to $16,500 in a 401(k) or $5000 in an IRA. If you are 50 or older in 2009 you can put $22,000 in a 401(k) or $6,000 in an IRA.
This post is getting lengthy so I’ll wrap it up. My recommendation is to first take advantage of your employer match, then go with a Roth if you think your income will be higher in the future. I’ll do a follow up post on some investment recommendations. Visit the IRS for more information. Stay tuned for more.
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