Dissecting Retirement Accounts

As promised I am going to explain the pros and cons of different retirement accounts.  Feel free to ask questions in the comments if you want to know anything that I didn't cover or if something is unclear.

401k


A 401k account is a retirement account that is set up through your job that encourages you to save for retirement.  Don't worry about the name, it is just the tax code.  Most employers will "match" your contributions up to a certain amount.  For example, my old job would match 50 cents to every $1 I contributed up to 6% so as long as I contributed at least 6% of my paycheck before taxes I would get a full match.  This is free money so if your job offers this and you are not participating I encourage you to get this set up, the more time you put it off the more money you are missing out on.

Traditional IRA


A Traditional IRA is an Individual Retirement Account in which you contribute a certain amount, whatever you choose up to the yearly limit, and reduce your taxes for that year.  Here's an example, say you made $20,000 at your job and you decided to put $3,000 into a Traditional IRA that same year.  When filing you taxes you would list your income as $17,000 instead of $20,000 and only pay taxes on the $17,000.  Instead of paying $1,355 in taxes you would pay $905 and cut your tax bill by $450.

Pros:

• Receive a tax break when filing your taxes for the year you contributed.
• While the money is in the account you will not pay taxes, you will pay taxes when you retire.
• You can take the money out penalty free to pay for a house or college for yourself or your child but you will have to pay taxes when you withdraw the money.

Cons:

• Every time you take money out in retirement you will have to pay taxes at your current tax rate, which keep in mind might be higher than your tax rate now.
• Once you turn 70 1/2, even if you don't need the money, you will be forced to start withdrawing money because the government wants their money, in taxes, since you got the tax break when you contributed to the account.

Roth IRA

A Roth IRA is a little different from a Traditional IRA, you don't get the initial tax break when you contribute to the account. 

Pros:

• Just as with a Traditional IRA you don't pay taxes on any of the money while it is in the account but you also don't pay taxes in retirement either.  Whether you withdraw $5,000 or $5 million you will not pay any taxes in retirement.
• Because you didn't get a tax break on the money contributed you can take any amount that you have contributed, but not your earnings, at any time for ANY reason because you already paid taxes on that money.  This means that you can take everything that you have contributed out for a vacation penalty and tax free.  I do not recommend this, of course.
• As soon as you turn 59 1/2 you can begin to withdraw you earnings if you wish to do so.
• If you pass away and the money that goes to your spouse, children, or any heir, they will not have to pay taxes on the money either.

Cons:

• You do not get a tax break when you contribute the money but this is the only con that I can think of

(My opinion is that the Roth IRA is a better investment)

*With any retirement account you can only contribute up to a certain amount, $5,000 for 2011 (or $6,000 if you are 50 or older) for both IRAs discussed earlier (not $5,000 for each account, only $5,000 for either account) and $16,500 (or $22,000 if 50 or older) for a 401k account but only if you have earned that amount or more during that year.  If you only earned $15,000 in 2011 you can only contribute $15,000 to a 401k account even if you have some money in a savings account.

**If your spouse is not working you can still contribute to that account, up to the yearly limit as long as you have earned that much.  For example, if you made at least $10,000 in 2011 you could contribute the maximum in each account. 

If a person in their early 20s puts $25/week into an IRA by the time they retire they will have over $1.1 million if their return is 10% (the average historical return in the stock market).  Check it out on moneychimp.com if you don't believe me.

Sources: irs.gov/publications/P590/index.html

MarksJarvis, Gail. Saving For Retirement Without Living Like a Pauper or Winning the Lottery. New Jersey: Pearson Education, Inc., 2007. Print.