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With an IRA you have access to a virtually unlimited selection of mutual funds, bonds, stocks, and money market accounts. This is in sharp contrast with the handful of choices available with most employer sponsored 401k plans. However, before you open an IRA you must first decide which is best for you: A Traditional IRA or Roth IRA? To help make this decision easier I have created this quick guide that covers the advantages of each.
Traditional IRAs:
Traditional IRAs allow you to make potentially tax deductible contributions into a brokerage account up to $5000 a year in 2008 ($6000 if you are over the age of 50). Unfortunately, this deduction goes away once your adjusted gross income (AGI) exceeds certain levels depending on your marital status and whether you or your spouse are covered by a retirement savings plan at work. The other downside is that all money withdrawn from a Traditional IRA will be taxed at your regular income tax rate at the time of your retirement. You may begin withdrawing funds from the account without penalty at the age of 59 ½. You may also withdraw the money penalty free (you still must pay regular income taxes) for qualified medical expenses, higher education costs, a qualified first home purchase, and other major life events. You are also required to begin taking minimum withdrawals from a Traditional IRA at age 70 ½.
Roth IRAs:
Like Traditional IRAs, you may contribute up to $5000 in 2008 ($6000 if you are over the age of 50) to a Roth IRA. The difference is these contributions are made with after tax dollars and are not tax deductible. You are ineligible to contribute to a Roth IRA if your income (AGI) is above $116,000 as a single filer or $169,000 if you are married and filing jointly. The advantage to the Roth IRA is that all contributions and any growth can be withdrawn TAX FREE at retirement as long as you are 59 ½ or older. And unlike Traditional IRAs you are allowed to withdraw your contributions penalty free (and tax free) at any time. Earnings on your contributions can be taken out penalty free for qualified medical expenses, higher education costs, a qualified first home purchase, and other major life events. There are no mandatory withdrawals with a Roth IRA.
Which IRA is Best for My Situation?
Mathematically, if your income tax rate is the same now as it is in retirement, the numbers are a wash. However, if you are eligible for a Roth IRA and you expect your income tax rate to be equal to or higher in retirement than it is now, a Roth is most likely your best bet. Traditional IRAs are good if you prefer the tax deduction now and expect your tax rate to be less in retirement. The idea is you want to maximize the value of your tax break whether it is now or later.
How Do I Determine What My Tax Rate will be in Retirement?
If you are currently earning a good income(>$40K), have no pension, are within 10 years of retirement, and don’t have a large amount of retirement savings, more than likely your Tax Rate will be lower in retirement and you may find a Traditional IRA more beneficial. On the other end if you are 20 or more years away from retirement, with a steady job, and have been consistently investing 10-15% of your income into your retirement accounts, you very well may have a higher Tax Rate in retirement in which case you should consider a Roth IRA.
*Remember this information is intended as a guide. Be sure to consult a licensed tax professional because individual circumstances may vary.
{ 3 comments… read them below or add one }
hi!
I currently have a 401K and 403B through my employer in which I am 100% vested. I accepted a position with a different company in which the same benefits exist but I will not be fully vested with them for 5 years. Should I roll my money over into an Individual IRA and start over with this company or roll my retirement over to the new employers retirement?
Thank you for your advice.
Rhonda,
In most cases it is better to roll your money over into an individual IRA. The reason is quite simple, most empoyee 401K and 403B plans have very limited investment options.
By rolling the funds from your previous employer into an IRA, you will have more investment options and will typically have lower costs.
I would look into Vanguard, Fidelity, or USAA (if you’re eligible).
Good luck with your new job, and please let me know if you have any additional questions!
remember, this is what I would do in your situation. You may wish to seek the advice of a professional
Ben