Catch a Gideon

What’s MY Best Retirement Option

March 21st, 2007 by digerati

I am often asked what the best investment option is between an IRA and a 401(k). This is a tough question especially given everyone’s varying backgrounds. I’ll attempt to cover them all briefly.

401(k); 401(k) is the pension replacement account. The employee puts money in and this money is taken out of their salary before paying taxes (making it a tax deffered account). Employers often match a percentage of the employees contribution (often 3-5%). Employee contributions to 401(k) accounts are capped at $15,000 for 2006 ($19,000 if you are over 50). Total contributions are capped at $44000 ($49,000 if you are over 50).

IRA: Individual retirement accounts work in a similar manner. The individual takes money they have earned and deposits it in an IRA account. The money can then be deducted from their income for that year for tax purposes. When the money is removed from the account you will pay taxes on it as income. The idea is that you will be in a lower income bracket when you remove the money so the taxes will be less. Also, the money accumulates tax free in the account (no capital gains, etc).

Roth IRA: similar to an IRA in that it is an individual account. Roth IRA’s differ in that the income you put in is taxed normally as part of your income. When the money is removed (much later) there is no tax on the amount you take out. There are no taxes paid on capital gains, just like with a 401 or IRA. With a Roth account you are trading paying taxes on the money now and not paying them later.

Roth 401(k). This is a rare optio you can READ ABOUT HERE! Roth 401s work similar to Roth IRAs: you are trading paying taxes on the money now for not paying taxes on the money later.

Some notes

• 401(k) (including Roth) contributions are capped at $15000 for 2006.
• Roth IRA contributions are capped at $4000 for 2006, $5000 for 2008 and will increase with inflation after that.
• You can contribute to both a Roth IRA and a 401k.
• Roth IRA accounts are available only to those earning less than some amount (about $110,000 for 2006).

So which account should you use?

In your 20s/30s/make under $100,000 a year

First contribute to your 401k (or Roth 401k) as much as your employer will match. After you have gained the maximum matched amount, add to your Roth IRA contributions for the year. After that continue to add to your 401k until it is maxed out or you cannot contribute more toward retirement.

Here’s why: Matching is a 100% return on investment, you won’t find this deal anywhere else. After matching, the Roth IRA is the best option. You are in a low income bracket so you are better off paying the taxes on the money now rather than later.

Roth 401(k) available

Max this out first (it is easier to manage a single investment account than multiple). Then max your Roth IRA. The trick with Roth 401s is that the matched portion is still taxed as if the account were a normal 401 account. This is complex but probably not on your end. The advantage of the Roth 401 is that when you leave your job you can roll it over into a Roth IRA rather than a standard IRA. This means still no taxes when you withdraw the money.

Over $100,000 a year?

I’d recommend the standard 401k to its max and then an IRA. You don’t want the Roth options here (in most cases). You would rather not pay tax now (in your probably higher tax bracket) and instead pay the tax when you withdraw the money (in a probably lower bracket).

Own your own business?

Contribute first to your 401k account and setup matching. This is fairly complicated and you should find an advisor who handles small business 401 accounts. If you are making enough money (and your company is making enough money) you can try to max the 401 employer contribution as well. The employer (which is you here) can contribute up to 20% of your salary, but also (I think) contribute a base amount. The end result is up to $44,000 a year placed in your 401k account. After that contribute to an IRA.

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