Last week I wrote about some of the basics of the different kinds of retirement accounts-- so if you need some information about how retirement accounts work, and what the difference is between an IRA and a 401(k) and what the heck "Roth" means, go read it.
However, understanding retirement accounts is only step one. Now you've got to decide which account(s) to use. Here are some things to keep in mind:
IRAs vs work-based accounts (401(k)/403(b)/Thrift Savings Plan)
- Look for the employer match. It's pretty obvious, but if you're getting a match from your employer, it's almost certainly your smartest bet to take advantage of that first.
- Convenience. 401(k) deductions come right out of your paycheck, which means they'll happen regularly and you'll never touch the money and risk spending it. (Most IRAs will let you set up automatic deductions from your bank account, which can help replicate most of this.) On the other hand, if you leave your employer and you have less than $5000 in your 401(k), you may have to deal with rolling over the money to a different plan, which isn't that hard to manage but is a hassle nonetheless.
- Freedom to choose investments. Your 401(k)/403(b)/Thrift Savings Plan will have a limited number of investment options that you can choose between, and there are a variety of reasons why you might not be happy with them. (We'll talk more next time about how to evaluate your investment possibilities.) With IRAs, you can search far and wide for exactly the investment choice(s) you want and then open an account somewhere that offers it.
- Minimum balance. Most IRAs/Roth IRAs have minimum amounts you need to invest in order to open an account, like $1000 or $2000. (Sometimes they'll lower that minimum if you sign up for automatic monthly contributions from your bank account.) If you just can't spare enough to invest a lump sum like that right now, then you'll want to go with your 401(k) instead.
- Last day you can contribute. Your 401(k) deductions reduce your taxable income the year they're deducted; however, you can make "prior year" contributions to IRAs up through April 15 (ie, you can make your 2008 contributions anytime between January 1, 2008 and April 15, 2009.) This is especially relevant if it's springtime and you're looking for ways to reduce your prior-year taxable income-- you just can't do that with a 401(k).
Roth vs Traditional
- The long-term strategy. Whether it's wiser to put your money in a Roth account or a traditional account essentially depends on whether you think your tax rate will be higher or lower in retirement than it is today (since Roth accounts use after-tax money today that's tax-free in retirement, while traditional accounts use pre-tax money today that's taxed in retirement.) Predicting the tax rates of the future is obviously a difficult and uncertain endeavor. (Although if you are in a low tax bracket now but are aiming to be pretty well-off in retirement, that's a sign to strongly consider focusing on Roth accounts.) One good way to deal with the uncertainty is to do a little of both-- have some money in Roth accounts that will be tax-free at retirement, and some that are traditional and taxable at retirement.
- Effects on your taxable income today. Traditional accounts will lower your taxable income; this may help bring you below the income cutoff that allows you to qualify for various tax benefits. (One nice tax credit is the Savers Tax Credit where if you save for retirement you can get a credit of up to $1000 if your income is under $26,000 single/$52,000 married filing jointly; you qualify for the credit if you save in either a Roth or traditional retirement account, but if you're a little above the income cutoff, it's probably smart to use a Traditional account to lower your income in order to qualify. But this principle applies for other tax credits too.)
- Maxing out your accounts. If you are planning to invest the maximum allowed into your retirement account(s), investing the $5000 max in a Roth IRA and keeping all the proceeds will mean you almost certainly end up with more at retirement than if you invest the $5000 max in a Traditional IRA but then have to pay taxes on the proceeds at the end. The same applies with the maximum of $15,500 in a Roth 401(k) vs $15,500 in a traditional 401(k).
- Early withdrawals. Roth IRAs (but not Roth 401(k)s) allow penalty-free withdrawals of your money for any purpose, whereas traditional IRAs have a 10% penalty (except for a couple exceptions like medical costs, first-home expenses, and higher ed costs.) Obviously it's better to leave your retirement money in the account and let it grow, but if your worries about emergencies make you hesitate to save as much for retirement, knowing you can access the money in your Roth IRA can give you more peace of mind.
Got all that? Well, hang in for next time, when we'll talk about investments to go in these accounts (including but not limited to Socially Responsible Investment/SRI options.) And ways to think about how much you should be saving for retirement!
As always-- any questions? Anything to add? Chime in in the comments...