Roth IRA vs Traditional IRA

An IRA is an Individual Retirement Arrangement that provides tax advantages.  Generally, there are two types of IRAs to choose from, Roth IRA or Traditional IRA.

• A Roth IRA is funded with “after-tax” money, or money that has already been subject to income tax.  The Roth IRA grows tax-free and withdrawals at retirement are usually tax-free.
• A Traditional IRA is funded with “pre-tax” money, or money that has not been subject to income tax.  The Traditional IRA grows tax-free withdrawals at retirement are taxed as income.

There are several advantages/ disadvantages to both IRA types.  The main difference is getting the tax break now or when you retire.
Some reasons I Like the Roth IRA…

• Direct contributions to a Roth IRA may be withdrawn tax free at any time.  (May not withdraw Traditional IRA contributions without incurring penalties)
• Contributions may be made to a Roth IRA even if the owner participates in a qualified retirement plan such as a 401(k)  (Contributions may be made to a traditional IRA in this circumstance, but they may not be tax deductible.)
• The Roth IRA does not require distributions based on age.  (All other tax-deferred retirement plans require withdrawals to begin after the owner reaches age 70½)  (Great way to leave money to your heirs)

Some reasons I Don’t Like the Roth IRA…

• Contributes to a traditional IRA instead of a Roth IRA get an immediate tax savings.
• A taxpayer who pays state income taxes and who contributes to a Roth IRA will have to pay state income taxes on the amount contributed.  However, if the taxpayer retires to a state with no income taxes, then the taxpayer will avoid paying state income taxes altogether by instead contributing to a traditional IRA.
• The perceived tax benefit may never be realized with a Roth IRA.  Early death or a short retirement period may reduce the full benefit.  One must live until one’s Roth IRA contributions have been withdrawn and exhausted to fully realize the tax benefit.
• Congress may change the rules that currently allow for tax free withdrawal of Roth IRA contributions.

Hopefully this helps simplify the complicated world of IRAs.  A great, easy to read, chart can be found on Wikipedia, here.

Easy and Simple 401k

What is a 401k and why should I care?

1. A 401k is offered by companies to workers as a way to save for retirement.
2. The 401k is funded with pre-tax money, meaning you haven’t paid taxes on it yet.
3. Some companies might offer a 401(k) match up to a dollar amount or percentage.
4. The 401k will grow, tax-free, until retirement age, when you can withdraw the money.  The 401k is taxed when the money is withdrawn at retirement.
5. The employee can select from a number of investment options (Mutual Funds, Stocks, Bonds, Etc)

This is a lot of information to understand so let’s break it down more…
1. First off, 401ks are company sponsored, or set up with the company you work for.  You are responsible for enrolling yourself.  And you absolutely should!  The sooner you enroll the more  money you will gain.  25% of workers fail to sign up.  Don’t be that person.
2. 401ks are funded with pre-tax money.

Let’s say I put $100 into my 401k and I invest $100 on my own.  The $100 that I invest on my own actually costs me $118 because I have to pay income taxes on it (15% or so).  THIS IS HUGE!

3. 401k company matches are great and take full advantage of them.  Most companies will match your 401k contributions up to a certain percentage or dollar amount.  THIS IS FREE MONEY!

If your company has a 3% 401k match, then absolutely put 3% in your account.  At the end of the year, your company will also put in 3% for a total of 6%.  If you only put in 2%, your company would also only put in 2% for a total of 4%.  In other words, by only contributing 2% instead of 3%, you are actually cutting your retirement 2% (6%-4%).  TAKE FULL ADVANTAGE OF THE COMPANY MATCH!  FREE MONEY!

4. 401ks grow tax-free.  The Earlier you start, the better.  The following charts are based on the exact same information except for the number of years.  Chart 1 is based on 25 years of contributions (age 35 - age 60) and Chart 2 is based on 35 years of contributions (age 25 - age 60).  Basically, if you start saving now, you will have OVER TWICE AS MUCH WHEN YOU RETIRE!
Chart 1 is based on 25 years of contributions (age 35 - age 60)
Total Contributions of $33,892 with earnings of $208,107

25 Years of Contributions

Chart 2 is based on 35 years of contributions (age 25 - age 60)
Total Contributions of $49,992 with earnings of $511,634

35 Years of Contributions

Charts based on…
8% Rate of Return
3% Contributions
3% Company Match
$40,000 Annual Salary

5. Last of all, you can choose from a select number of investment options.  Don’t let this scare you and just pick a good mix of stocks, mutual funds, and bonds.  Bonds are for old people.  Stocks are for younger people.  Stocks are more risky but generally offer a better return.  Bonds are less risky and offer a lower return.
My personal view is:  Under 50 = good mix of stocks, no bonds.

Some other notes on 401ks…

• Don’t worry about switching jobs, you can take your 401(k) with you
• You will pay Income Tax on the money you withdraw around retirement age
• In 2008, you are limited to putting $15,500/year in your 401k
• You can Withdraw your money before you’re 59.5 years old, but you will have to pay  a 10% Penalty
• Special Early Withdrawal exceptions…such as a down payment to a house
• Automatic payroll deductions make it super easy to start a 401k
• YOU HAVE TO SIGN UP, THE COMPANY WILL NOT DO IT FOR YOU!