Individual Retirement Plans: 401(k)s For The Rest of Us

Posted on | August 21, 2007 | No Comments

If you are currently working for an large employer, you’ve probably got a access to a 401(k). For you, retirement saving is only an HR manager away. For those of us who are self-employed or working for startups and small businesses, starting to save for retirement may take a few more steps.

The first step is understanding our options. Our best retirement saving option is the Individual Retirement Account, or IRA. IRAs allow us and our spouses, whether currently employed or not, to save money and earn income on your investments until we withdraw the money. There are 11 types, but I’d like to focus on the The Traditional IRA and the Roth IRA in this post.

The table below compare these two types of IRAs. Note that neither requires a minimum contribution and both are available most everyone (though the cutoff is age 70-1/2 for the Traditional IRA).

Which one is right for you?

I can’t definitively tell you what is right for your situation; the answer truly depends on what you want from your retirement, the amount of money you’ll need to maintain your lifestyle after retirement. But, I can give you some guidelines for making the decision.

The most significant differences between the two lies in the how contributions and withdrawals are treated. Money you put into your Traditional IRA is not taxed like the rest of your income; your contributions and earned income are tax-deferred. For example, if you earned $50,000 last year and put $2,000 in your Traditional IRA, you would only be taxed on $48,000.

Money you contribute to your Roth IRA is not tax-deductible. Using the above example, you must pay taxes on the $2,000 you put into your Roth IRA the same as you would the rest of your income.

At first glance, the Traditional IRA seems better. But, consider that when you withdraw money (both your contributions and any earnings) from your Traditional IRA, you will be have to pay the taxes on both; the Roth IRA allows you to deduct your contributions and earnings tax-free (as long as the account is 5 years old and you’re over age 59-1/2).

So, the question really is when do you want to pay taxes on your savings and earnings–now or later? If now, choose the Roth IRA (you’ll pay taxes only on your contributions because they are part of your income); If later, choose the Traditional IRA. But, keep in mind, that with the Traditional IRA you will pay taxes on not only the contributions you made, but also on any earnings on your investment over the life of the account.

The other big considerations are (1) how long can you leave the account untouched, (2) the amount of your gross income (your compensation), (3) the size of your account and (4) your tax rate now versus at retirement and (5) how you will pay the tax bill upon withdrawal (applies to the Traditional IRA).

If you intend to, or you suspect that, you may need to withdraw funds from your account sooner rather than later, the Roth IRA is probably your best option because it allows you to withdraw your principal contributions to buy your first home or pay educational expenses (if the account is at least 5 years old). You may even withdraw up to $10,000 of your earnings tax- and penalty -free from the Roth IRA to cover first-time homebuyer expenses (if earnings have been in the account for at least 5 years).
If you are under 70-1/2, exceed the gross income limits for the Roth IRA (meaning your compensation is more than $113,999 for single filers/$165,999 for married joint filers), are able to leave your retirement account untouched until after retirement, and don’t want to pay taxes on money that you aren’t currently living on, and anticipate growing your earnings enough to cover your taxes at the time of withdrawal, the Traditional IRA will suit you just fine.

To learn more about IRAs, check out these resources:

• Motley Fool’s IRA Glossary
• The IRS Online IRA Resource Guide
• Kiplinger’s Retirement Tools

Companies offering IRAs:

• Banks
• Financial Services Firms
• T. Rowe Price Retirement Center
• Charles Schwab

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