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Roth IRA, 401(k) and 403(b) Plans


Roth IRA

The Roth IRA is very similar to the Traditional IRA except that the way taxes work with regard to the account is different. Roth IRA participants pay taxes on the money they contribute into the account up front (in the year they make the contribution). This is in contrast to the Traditional IRA where contributed monies are tax-deductible in the year they are contributed. Like a Traditional IRA, monies in a Roth IRA remain tax sheltered for the duration of their investment. Unlike a Traditional IRA, however, monies that are withdrawn from a Roth account are not taxed (!). This last feature is what makes Roth IRAs so wonderful. You never have to pay taxes on the money you withdraw from them. IRA investors expect that their money will grow over time. You start with a smaller amount of money at first and later end up with a larger amount of money. Young people are generally better served by investing money into a Roth IRA than a Traditional IRA. By investing with a Roth, you pay taxes on a smaller amount of money now, and then do not have to pay taxes on what is (hopefully) a larger (compounded) amount of money that is withdrawn years later. The reverse is typically true with the Traditional IRA. Consult a qualified financial advisor if you have questions regarding which type of IRA will best suit your individual needs.

One difference with a Roth IRA versus a Traditional IRA is that you can continue to make contributions past the age of 70 ½. Otherwise the same restrictions apply. There are annual deposit limits that are age-corrected for those under and over age 50. You must be 59 ½ before you can take a penalty-free withdrawal on the account (excepting financial hardship cases).

Roth IRAs are not available to higher wage earners.  These limits are expected to change every year with inflation, so check with this IRS page (http://www.irs.gov/Retirement-Plans/COLA-Increases-for-Dollar-Limitations-on-Benefits-and-Contributions) for the current limits.

The benefits of Roth IRAs increase the more time you have to invest. The accounts are less beneficial (as compared to a Traditional IRA) when retirement time frames are shorter. Roth IRAs are better suited to younger workers (those in their 20s and 30s) than to older workers. Such workers are typically in lower tax brackets and would benefit from paying taxes upfront rather in retirement when it is likely that their tax bracket will be higher. The reverse may be true for older workers.

401(k) and 403(b) Employee Sponsored Retirement Plans

Most people become familiar with retirement planning through their work. Most for-profit companies offer some sort of 401(k) retirement investment vehicle to their employees. The name 401(k) refers to the part of tax law that created this type of account. The 401(k) allows employees to save money for retirement in a tax-deferred investment account until funds are withdrawn at retirement. 403(b) plans are similar types of accounts offered by hospitals, churches, or educational entities.

401(k) plans are employer sponsored retirement savings accounts that can be the primary vehicle for your retirement planning. You can contribute a percentage of your pre-tax income to your 401(k) by establishing a monthly payroll deduction with your human resources or personnel department. This is the best way to fund your 401(k) as it requires no discipline on your part. What is even better is that many companies will match employee contributions up to a certain percentage. If your employer provides matching funds, be sure to take advantage of the program as you will make money immediately. Not taking up your employer's offer of matching funds is like refusing extra compensation.

Almost anyone who is gainfully employed may participate in an employer sponsored 401(k). High earning employees are excluded however. Additionally, you may only contribute a certain amount each year. These limits are expected to change every year with inflation, so check with this IRS page (http://www.irs.gov/Retirement-Plans/COLA-Increases-for-Dollar-Limitations-on-Benefits-and-Contributions) for the current limits.

Although the employer establishes the 401(k) plan, the employee is responsible for making most of the investment decisions. 401(k) plans invest in mutual funds which are a collections of stocks and bonds. Typically, you will have 6-8 different investment options to choose from. Each mutual fund will have different investing objectives and it is up to you to pick the ones that are in line with your goals and tolerance for risk.

The tax shelter that 401 and 403 accounts offer is similar in nature to that offered by the Classic IRA. Since you do not pay taxes on the monthly contributions, withdrawals made at retirement-time are taxed as normal income. You can begin withdrawals without penalty at the age of 59 ½ or prior to that under special circumstances (financial hardship, to fund a down payment on a home, etc.). When you leave your employer you may be able to leave your 401(k) with them or have the funds transferred to a Rollover IRA that you can exert more direct control over.