IRA, Roth IRA, Roth 401K Guide: How Are They Different?
In addition 401K plans, there are two other outstanding tax deferred accounts, Individual Retirement Accounts (IRAs) and Roth Individual Retirement Accounts (Roth IRAs). These are especially important if your company doesn't offer a 401K or if you have reached the maximum contribution for the year in your 401K but still have money to invest. Many people choose to contribute to both, just make sure you max out your company's 401K match before any dollars go into an IRA account.
IRA & Roth IRA Similarities
Let's talk about the similarities of these two types of accounts first. Since 401Ks are an employer's retirement benefits program, they will usually provide information about the program, encourage you to contribute, assist you in setting up automatic paycheck withdrawals, and even give you limited guidance on investing. IRAs and Roth IRAs are quite different in this respect. Like their names suggest, they are individually directed accounts so you'll have to sign up for them on your own.
Fortunately, some brokerages make signing up for IRAs and Roth IRAs very easy to do. For example, our favorite tax deferred account provider is Schwab.com. They don't charge any type of maintenance fees, they have low minimum investment requirements, and they make it very easy to open either type of account online in half an hour or less.
IRA Contribution Limits and Roth IRA Limits are the same and these often change year to year, but to keep things simple we'll only discuss the current year in this intro. In 2008 you were able to contribute $5,000 to either type of account (not both) if you are less than 50 years old and $6,000 if you are 50 or over. However, you certainly don't have to contribute the maximum. If you only have a small amount of money, it should still go into an IRA or Roth IRA rather than a taxable account. Remember the compound interest example above and ALWAYS choose the tax deferred account when you have the option.
IRAs and Roth IRAs share similar hardship withdrawal exceptions as well. In certain circumstances, you will be able to withdraw money from your tax free accounts without paying any penalty over your normal tax rate. For example, you can take out up to $10,000 for a primary home purchase. Both IRA types will also allow you to withdraw qualified education expenses of the IRA owner, children, or grandchildren. And finally, you can withdraw for qualified unreimbursed medical expenses or for medical insurance during periods of unemployment.
The last similarity worth mentioning is that regular distributions can begin from your IRA or Roth IRA account at age 59 1/2. In addition to this age requirement, the Roth IRA requires that any money withdrawn must be "seasoned" which just means it has to have been in the account for at least 5 years.
IRA and Roth IRA Differences
The similarities are pretty generic, now I can talk about the advantages and disadvantages of IRAs vs. Roth IRAs. After we've explained what makes each of these tax deferred accounts unique, you can decide which one is best suited to you.
There are two major differences between IRAs and Roth IRAs, and the first one we are going to talk about is how they handle taxes. When you contribute to an IRA, you are allowed to reduce your taxable income. This is a very popular feature of the IRA because it increases your tax return. The Roth IRA doesn't allow you to deduct contributions from your taxes. In other words, you can put money in, but unlike the IRA, it will not reduce your tax liability. Once money is in either type of account however, they behave the same, you can invest tax free without having to worry about taxes on dividends or gains until you withdraw.
You're probably wondering why you would invest in a Roth IRA if the IRA provides a better tax shelter, right? That's easy, and the answer is the second major difference between the two types of accounts. IRAs penalize you substantially for withdrawing money, you will pay taxes on both your gains and the amount you invested plus a 10% penalty. When you make the decision to put money into an IRA, make sure that it's not part of your emergency fund or money you will need soon. The Roth IRA has a huge advantage in this category. It allows you to withdraw every penny you invest at any time without paying a taxes or penalties. This means that you can reap the benefits of tax free investing without losing access to your hard earned cash.
There is another benefit that is exclusive to the Roth IRA and which is quickly making it the more popular of the two. Let's say you decide to leave your money in your Roth IRA until you can begin taking out regular distributions at age 59 1/2. When you start taking regular distributions they won't be taxed! Since you didn't get the tax deduction when you put the money into the IRA, you will not have to pay taxes when you start taking regular distributions at retirement.
Another benefit of the Roth IRA is that you are never forced to start withdrawing funds. You can keep your tax free money protected in a Roth IRA account until you decide you need it or until death, whichever comes first. IRAs on the other hand force you to start withdrawing funds at when you turn 70 1/2 unless you are still employed.
Finally, the Roth IRA is the only tax deferred account that has income limitations. You can contribute the full $5,000 in 2008 ($6,000 if you're 50+) as long as you make less than $101,000 per year as a single filer or less than $159,000 as a joint filer. There are no income limitations on the IRA, it allows anyone to invest the full amount regardless of income.
Still having trouble deciding? Here are a few critical questions that sum up the advantages and disadvantages of each.
- Will you be in a lower or higher tax bracket in the future? If lower, the IRA is better, take the tax advantage now and then withdraw at a lower tax rate. If higher, a Roth IRA is better, pay the taxes now and enjoy tax free earnings when you withdraw later at a higher tax bracket.
- Is this money that you will need before retirement? If you know you won't need this money and won't have to worry about withdrawal penalties, then it doesn't matter which option you choose. If you may need this money for something, choose the Roth IRA since it lets you withdraw all the money you contributed at any time without penalty. Self employed people or people that have a very tight budget are likely to enjoy this option because you can still access your money in the event of an emergency.
- Will you need this money later? If this is an important part of your retirement income, then it doesn't matter as much which type of account you choose. If, however, you aren't sure if you'll need these funds during retirement and would like to have the option of not cashing out, choose the Roth IRA. A regular IRA will start mandatory distributions at age 70 1/2 and they will be taxed.
- What is our personal opinion? IRAs and Roth IRAs are both wonderful wealth building tools because they allow you to invest tax free. There are advantages and disadvantages to each one, but if we had to choose one for you, we would recommend the Roth IRA because of all the flexibility it offers. You can withdraw your money in the event of an emergency, you won't be taxed when you start taking distributions, and you can leave the money in this wonderful tax shelter for as long as you want.
I wanted to throw in a short blurb about the Roth 401k. While they're a new animal (only around since 2006), they'll likely become popular quickly. The differences between a 401K and a Roth 401K are nearly the same as the differences between an IRA and a Roth IRA. If your employer offers one, remember that the Roth 401K will give you much more flexibility around withdrawing money and will also allow you to withdraw tax free distributions at retirement. For the record don't withdraw money until retirement! But it's nice to have the option in case of emergencies. Obviously you also lose the tax deduction advantage up front, but most people finish their careers in a higher tax bracket than they started anyway. This is a particularly strong option for career minded people that are likely climb the corporate ladder getting raises all along the way, you'll definitely finish in a higher tax bracket so this should be a no brainer for you.