Retirement accounts: To Roth or not to Roth?
Let's clear up the confusion about the basics of IRAs and 401k's, including whether to go with Roth or traditional.
This post comes from Maryalene LaPonsie at partner site Money Talks News.
At Money Talks News, we talk a lot about retirement.
We've told you how to retire rich, and we've told you how to retire poor. We've told you about the retirement mistakes you're making, and we've even told you why retiring at age 66 may be a bad, bad idea.
But maybe you've read through those articles and felt a little lost with the acronyms and letters sprinkled in between all that talk of compound interest.
Don't feel bad if you're confused. The government doesn't like to make anything easy. Just check out the IRS page on retirement plans for proof. If you really want to know everything there is to know about tax-sheltered retirement plans, you can do some heavy-duty research on the IRS page.
Or, for an easy-to-understand overview of the most common options, you could keep reading below.
To Roth or not to Roth
First, we need to discuss the difference between traditional and Roth accounts. Traditional accounts are set up so your contributions are tax-free. For example, if you put $5,000 into a traditional IRA, you get to deduct that $5,000 from your taxable income at tax time. Then, when you retire, you pay taxes on the money as you withdraw it.
In addition, traditional accounts require participants to begin withdrawing a certain amount of money, known as required minimum distributions or RMDs, by age 70½. The RMD depends on the age of the plan holder and value of the account. Failure to take the minimum distribution can result in hefty fines.
Roth accounts are relatively new. They are named in honor of U.S. Sen. William Roth, who helped usher them in as part of the Taxpayer Relief Act of 1997.
With a Roth account, you pay taxes on your contributions now but not on your withdrawals at retirement time. In exchange for skipping the tax break during your working years, your money in retirement becomes tax-free. What's more, there are no RMD requirements with Roth accounts.
Picking the right account
Roth accounts seem to be a better deal on the face of it. Let's consider that $5,000 you've deposited and assume it's grown to $50,000 by the time you retire. With a Roth account, you'll have paid taxes only on the $5,000, while with a traditional account you'll end up paying taxes on all $50,000. Which would you prefer? Thought so.
However, before you automatically go the Roth route, you'll need to factor in taxes. If you're paying taxes on all of your retirement contributions right now, that might leave you with less money to set aside in a retirement account.
For example, with the deduction offered by a traditional account, you may be able to put $5,000 into your retirement fund each year. But if you are paying taxes on that money, you may have only $3,000 available to put into a Roth account. By putting more money in your account, especially at a younger age, you may find you come out ahead with a traditional account even though you're paying taxes on more money.
That said, if we're talking a dollar-for-dollar comparison, a report from T. Rowe Price (.pdf file) finds that putting money in a Roth IRA almost always gives you more spendable income in retirement than the same amount deposited in a traditional IRA.
According to the investment firm, the only time it may make financial sense to use a traditional account is if you are over age 50. Even then, a traditional IRA gives you more money only if your tax rate drops somewhere in the vicinity of 9 percent once you reach retirement.
A competent financial adviser should be able to help you run some numbers and make the right choice.
Now, let's consider two of the most common plans used for retirement.
When traditional pensions were shown the door by employers, many companies replaced their defined benefit plans with 401k’s.
The name comes from the section of tax code in which you’ll find the plan outlined. Most employers offer 401k plans, although 403b and 457b plans are similar options offered by nonprofit or state and local government employers, respectively.
Employer matching funds. Some employers will put a set amount of money into the 401k -- say, 3 percent of your annual income. You can also make your own contributions, and many employers will match a portion of the amount you deposit.
For example, an employer might match dollar for dollar your contribution up to an amount equal to 3 percent of your annual income. Or they may match 50 cents of each dollar, up to 6 percent of your income.
The actual percentage and match amount will depend upon your employer, but the bottom line is this: If your employer offers a match, you want to ensure that your contributions will max out the matching amount. Otherwise, you're leaving free money on the table.
However, you'll need to work at your employer for a certain length of time to become vested -- that is, to get access to all the money your employer is contributing on your behalf.
Most 401k plans will let you pick from several different funds in which to invest your money. Whatever those funds make plus your and your employer's contributions is what you'll have to live off in retirement.
Contribution limits. In 2014, 401k plans have the following employee contribution limits:
- $17,500 for regular plans, plus $5,500 for those age 50 or older.
- $12,000 for SIMPLE plans (Savings Incentive Match Plan for Employees -- generally offered by small businesses), plus $2,500 for those age 50 or older.
Once money is placed in a 401k, it cannot be withdrawn without penalty until you reach age 59½.
IRAs: Individual retirement accounts
After a 401k, your next stop for retirement savings should be an IRA, which stands for individual retirement account or, sometimes, individual retirement arrangement.
An IRA works just like a 401k in that you are investing money and letting that money grow until retirement. Again, you can't withdraw money without incurring penalties until age 59½.
Some IRAs may be employer-sponsored, but those accounts typically don't come with any matching funds. Instead, the benefit of an employer-sponsored IRA is that you can easily fund it through payroll deductions.
However, even if your employer doesn't offer an IRA, you can still set up your own through most brokerage firms and get the same tax benefits.
Contribution and deduction limits. For 2014, you can make the following contributions to an IRA:
- $5,500 for those age 49 or younger.
- $6,500 for those age 50 or older.
These contribution limits apply to all of your Roth and traditional IRAs combined. So if you're 45 and have two IRAs, you could put $3,000 in one and $2,500 in the other; you can't put $5,500 into each one each year.
In addition, those who have a retirement plan at work and are contributing to a traditional IRA may find they are unable to deduct the entire contribution if their income is too high.
For 2014, if you have a retirement plan at work, you can take a full deduction of your IRA contribution as long as your modified adjusted gross income is $60,000 or less and you file as a single or head of household. Married couples or qualifying widow(er)s can take a full deduction if their income is $96,000 or less.
The deduction phases out as income increases. Single and head of household filers lose the deduction completely once their income hits $70,000. Married couples and qualifying widow(er)s can earn as much as $116,000 before they lose their IRA deduction.
There are no income limitations for individuals who do not have a workplace retirement plan.
Roth IRA contribution limits. Since contributions to Roth IRAs aren't deductible, there are obviously no deduction limits for these accounts. However, there are income limits on who can make contributions to Roth IRAs.
Single and head of household filers can have modified adjusted gross incomes of up to $114,000 and make a full Roth IRA contribution. The contribution amount then begins to phase out until an individual’s annual income hits $129,000. At that point, they can't contribute to a Roth IRA.
For married couples and qualifying widow(er)s, their income can reach $181,000 annually before their Roth contribution amount begins to phase out. Once their income reaches $191,000 per year, these taxpayers are no longer eligible to make Roth IRA contributions.
There you have it: the nitty-gritty of some of the most popular retirement accounts.
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Just pay yourself first EVERY PAY PERIOD in a well thought out investment plan...do this over time and you will come out ahead...simple as that!
Don't make it complicated...and please don't hold out your beggar's hand when you don't do this and focus on the here and now more than your retirement years. Save or starve. The cell plan, large TV, or nicer car aren't as important as the money you won't have when you can't work anymore.
Ask yourself this question... Are taxes going to increase or decrease in the future? Who ever says taxes will be lower in the future, with the national debt crisis, you are blind!!!! Pay the lower tax rate NOW and invest in the Roth IRA. That way all of your contributions and growth will be tax free when you retire. If you are older and creeping towards your retirement, say 50 or so, then Traditional may be the route to take. Taxes probably won't change a significant amount in a decade. If you are in your 20's- mid 30's, Roth IRA is the way to go. Hands down! In the end, as long as you're putting your money into something, you are moving forward.
Roth IRAs are the best deal a taxpayer will ever get from the government.
In Dec. 2012 I moved some bank stock from an IRA to my Roth IRA. I knew it would grow as bank stocks had been beaten down. It was worth $25K and I paid the tax on this at 10% and 15% as I had very little income that year. It is now worth $39K and growing. At some point I will move it to something else but it still has growth potential and the dividend was just increase 67% and this should continue for some time. I had the funds to pay the tax without selling bank shares to pay the taxes due.
When I turn 70 1/2 I will not have to take mandatory disbursements from the ROTH as I will from other retirement accounts. PLUS -I do believe tax rates will have to be increased to pay the large Federal deficit.
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