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The Difference Between Roth IRAs, Traditional IRAs, and 401Ks

Have you decided you need to start saving for retirement, but don’t know where to start? You’ve come to the right place. This article will give you an overview of the benefits and drawbacks of three major types of retirement plans, and who might benefit from each type of plan. If you want to know more, keep reading.

Roth IRAs

Pros:

The money you put into a Roth IRA is taxed now, so you don’t have to worry about paying taxes when you take it out. This means that your investment can grow tax-free. This is good if you’re in a fairly low tax bracket right now compared to when you retire.

Another benefit of Roth IRAs is that you can withdraw your contributions at any time without penalty, no matter what your age. You can’t withdraw the interest you’ve earned, but you can withdraw what you have contributed.

Cons:

Having the money you put into your Roth IRA taxed now means you pay more in taxes now than you would have with a Traditional IRA. Besides that, you can only contribute to a Roth if you make under a certain amount. For 2011, that amount is $107,000 if you’re single, and $169,000 if you’re married.

There’s also a limit to how much you can contribute. For those under 50 years old, that limit is $5,000; for those over 50, it’s $6,000.

Traditional IRAs

Pros:

The money you contribute is tax deductible now, so you can get a tax break by depositing money. This may be good if you’re tight on money now but expect to have more later in life.

There’s no income limit for contributing to a Traditional IRA, so this is a good option for those who make over $107,000/$169,000 per year and don’t qualify for a Roth IRA.

Cons:

The money is taxed when you take it out, which means that you pay taxes on the earnings as well as the initial amount you put in. You generally end up paying more to the IRS this way.

Unlike a Roth IRA, you can’t withdraw your money before you’re 59 ½ years old without a penalty. If you try, you’ll have to pay taxes on the amount you withdraw (which you would have to do at retirement, anyway), plus a 10% penalty. This could negate most of the interest you’ve earned by putting your money in an IRA. There are certain circumstances in which you can avoid paying a penalty, such as if you are disabled or are using the money to pay medical expenses that are more than 7.5% of your adjusted gross income.

On the other hand, like Roth IRAs, contribution limits are fairly low compared to 401Ks. You can only contribute $5,000 per year if you’re under 50, and $6,000 if you’re over 50.

401Ks

Pros:

Your employer probably matches your contribution up to a certain point. That’s free money, and is sort of like earning 100% interest on your money (or 50%, depending on the rules of your particular company’s 401K). You’re not going to get that kind of interest with an IRA.

You can contribute up to $16,500 if you’re under 50, and up to $22,000 if you’re 50 or older. Plus, there’s no income limit, although if you make over $110,000, it may affect your contribution limit. Talk to your employer for details.

Cons:

You can’t take out that money before age 59 ½ except in certain circumstances, and you’ll incur a 10% penalty, plus any taxes. This could place you in a higher tax bracket, making you have to pay even more in taxes.

Besides that, 401K plans aren’t the same across the board. The rules of your particular company’s 401K will be different from another’s. This can make 401Ks very confusing. Most of the time, you will have fewer investment options with a 401K.

So which is the best?

Most financial experts recommend investing in a 401K up to your employer’s match, then investing anything above that in a Roth IRA. Traditional IRAs may be good if your current tax bracket is significantly higher than you expect your tax bracket to be at retirement, but for most people a Roth IRA is better.

When you decide to set up a retirement plan, it’s a good idea to consult a financial advisor to help you decide which assets to invest in inside your retirement plan and to explain all of the applicable laws to you. This article will hopefully give you somewhere to start, though, when considering what type (or types—you don’t have to pick just one) of retirement plan may be best for you.

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