401K Vs Traditional IRA Vs Roth IRA

On average, Americans are under-funding their retirements and are anxious about it. The federal government has introduced several defined benefit plans to encourage people to save and invest towards retirement, beginning with the 401k in 1982, followed by the traditional investment retirement account (IRA) and finally the Roth IRA. So what are they? How do you use them? Most importantly which one(s) should you use?

Retirement Savings Tools: 401k, Traditional IRA, Roth IRA & More

401k

401ks were conceived in 1978 as a supplement to company pension funds and quickly replaced them entirely. If you were born after 1985, you may not even be familiar with the concept of a company pension wherein companies guaranteed their retired workers a steady payment for the rest of the retiree’s life.

Pensions became impractical for both employees and employers. Many companies required 30 years of service to be eligible to receive your pension; this became more difficult to achieve in a job market that was increasingly fluid. Life spans rose and the costs of funding pension obligations soared. It is no surprise that many companies switched to the cheaper 401k.

With 401ks, employers do not guarantee employees any future cash payment. Instead companies usually only pay a third party, such as Fidelity for the management of employee 401k accounts. Employees are able to deduct a portion of their salary pre-tax and put it in their 401k accounts. Employees can then control how that money is invested, usually a mix of stocks and bonds. To encourage their staff to use 401k plans, the company may match employee contributions to the account.

Because it is intended to finance the beneficiary’s retirement, the 401k account has certain restrictions. Account holders cannot make withdrawals before age 59 ½ (or 55 if you leave your employer) without incurring a 10% penalty on the amount withdrawn. When you do withdraw the money, it is taxed as income. However, the growth in the account is tax deferred meaning the account is not charged tax for capital gains or dividend income.

The greatest immediate benefit of the 401k is that your taxable income is lowered by the amount of your deduction. Deductible contribution limits for 2013 are $17,500 or if you are 50 or older, $23,000.

Traditional IRA

But what if you are self employed or if your employer does not offer a 401k program? If you want to receive the same benefits of a 401k, you would want to open a traditional individual retirement account (IRA). This can be done at most commercial banks like Bank of America or Wells Fargo, as well as at brokerage houses like Vanguard or Scottrade, and your local credit union.

Traditional IRAs are essentially 401ks for people who do not or cannot have 401ks. When an employee leaves a job, she can even rollover her 401k into an IRA without incurring any taxes or penalties. The investor uses IRA funds to buy stocks, bonds or other investment assets that grow tax deferred. As with a 401k, withdrawals before age 59 ½ incur a 10% penalty in addition to the tax that all withdrawals incur, and mandatory minimum withdrawals are required beginning at age 70 ½.

If you earn taxable income and are under age 70 ½, you can contribute to a traditional IRA. Your contributions to your traditional IRA are fully tax deductible up to the annual limits (in 2013 $5,500 and $6,500 for persons under age 50 and over age 50, respectively) unless you have a 401k or other retirement plan at work. Spouses may fund their own 401ks and IRAs, subject to the standard individual criteria. However, if your spouse does not work outside the home, his contributions to his IRA account are only deductible if your combined earned income is less than $188,000.

You can also have both a 401k and traditional IRA, however if you have a 401k your IRA contributions remain fully tax deductible only if your Adjusted Gross Income (AGI) [http://www.irs.gov/uac/Definition-of-Adjusted-Gross-Income] is less than $59,000 (individual) or $95,000 (married with joint tax filing). Your contributions are partially tax deductible until you reach an AGI of $69,000 (individual) or $115,000 (joint filing), after which there is no deduction.

Roth IRA

There are advantages of savings plans beyond the immediate potential tax benefits. Most notably, a steady commitment to save regularly makes it more likely you will have sufficient funds when you retire. For this reason, you may consider funding your 401k and/or traditional IRA beyond the tax deductible limits. These additional contributions may not make an immediate impact on your tax bill but could affect your quality of life in the future.

Another option to consider is the Roth IRA. Contributions to a Roth IRA are made after tax. Withdrawals from a Roth IRA account are tax-free, unlike the 401k or traditional IRA, making it a better choice than over funding the latter two. Roth IRA funds are also used to invest in stocks, bonds and other instruments and the returns are not subject to capital gains or dividend income tax.

Roth IRAs are not subject to much of the criteria of a traditional IRA – there is no minimum required withdrawal at any age and you can contribute to Roth IRAs at any age. In addition, the early withdrawal penalty fee applies only to earnings, not contributions you decide to withdraw. This means if you contributed $100 to your Roth IRA and purchased bonds, you could withdraw the original $100 penalty free.

Other variations of the IRA that may be of interest to small business owners include the Simple IRA and the SEP IRA.

How to Choose Your Retirement Savings Plan

If you have access to a 401k at your current place of employment, it is your best first step in building your retirement. 401ks require little set up time and are highly automated (the pre-tax deduction is taken straight out of your paycheck). The 401k account custodian likely offers investment plans you can choose based on your financial goals and risk appetite. For example, if you are close to retirement you will want a more conservative and liquid investment mix since you will need to soon access the funds. Finally, many employers offer to match a certain amount of the funds employees contribute to their 401ks. This is free money!

The larger question is what additional retirement saving strategies you should employ. If you have a 401k, you should open a traditional IRA only if 1) your contributions to the IRA will be at least partially tax deductible and 2) if you are likely to have a tax bill where additional deductions would be beneficial. A tax and financial advisor can help you make this assessment. If both these criteria are not met, a Roth IRA would be a better choice for additional retirement financing.

If you do not have access to a 401k, a traditional IRA is the best choice to serve as a replacement assuming you have any tax burden. If your income is not taxable, a Roth IRA can serve as your primary savings vehicle.

Characteristic 401k Traditional IRA Roth IRA

Contributions are tax deductible Yes Yes No

Qualified distributions are tax free No No Yes

Employer sponsored Yes No No

Investments compound without tax impact  Yes Yes Yes

Early withdrawal penalty Yes Yes Yes*

Required minimum distributions Yes Yes

No

*Penalty only applies to earnings, not contributions.

How to Open and Invest an IRA

Banks, credit unions, and brokerages all provide IRA account management services. To open an IRA, you simply need identification and a social security number, as well as a regular bank account from which you’ll fund the IRA account. When selecting a custodian to manage your IRA account, make sure to check the fees they may charge and the minimum account balances the company may require. Many companies waive fees and minimum balances if you open the account online.

As you make your selection of account manager, it is important to also check the product offering and support offering. Companies offer products that range from very supportive where the company selects a ready-made investment mix based on your targeted retirement date and risk profile, to investor led where you trade stocks, bonds and other products using only the company’s platform. Honestly assess your own financial sophistication and choose a product that fits your needs.

Finally, it is important to develop an understanding of how much money you will need in retirement. This will allow you to make an estimate of how much to contribute now and how long you might have to work. The Financial Industry Regulator (FINRA) provides a helpful retirement calculator. Remember to save early, save often and take advantage of these retirement tools.

Category: Advice