Let's face it. Retirement issues can be confusing -- so much so that we often try to avoid thinking about them or doing anything about them. (That's why your friends at the Fool have launched an inexpensive monthly newsletter to help you get your ducks in a row. Easy to read in a single sitting and chock-full of inspiration and practical advice, Rule Your Retirement is worth trying for free.)
One of the confusing areas of retirement planning is what kind of account to use for your savings. There are traditional and Roth IRAs, 401(k)s, and more. While many people focus mainly on their 401(k) plan, they need to give more consideration to the Roth IRA.
Let's back up a bit, though, and define our terms.
With a 401(k) plan, you invest pre-tax money, which has the effect of decreasing your taxable income. Thus, you get your tax break immediately. Through the plan, you can typically invest in a variety of mutual funds. When you withdraw money, as you must generally do beginning at age 70 1/2, those funds are taxed at your ordinary income rate, which can be high.
With a Roth IRA, you invest post-tax money, and your tax break comes when you withdraw your money -- tax-free (if you've qualified and followed the rules). So if your Roth IRA holdings grow and appreciate for several decades, multiplying in value several times, and you get to keep all of it, paying no taxes. Nice, eh?
Here are some other benefits of the Roth IRA over the 401(k):
- IRAs offer more options. You can open them through your bank or your brokerage (check out our Broker Center for IRA fees for several major brokerages), or through some other financial institution, and you can invest that money in stocks, bonds, CDs, mutual funds, and even real estate. With 401(k)s, you're usually limited to what your employer offers you. It could be five funds or 100 funds, and many of them might not serve your needs well. If, for example, you (like Rick Munarriz) believe in the future of Steiner Leisure (NASDAQ:STNR) because of the solid performance of its cruise ships, and you'd like to invest some of your retirement in it, you probably can't do so via your 401(k), but you can through a Roth IRA. If you like the long-term prospects of Diamond Offshore Drilling (NYSE:DO) (read about its recent quarter), you can invest in it, too. And you can sell and buy other stocks, too, along the way. IRA accounts work pretty much like ordinary brokerage accounts in this regard.
- Roth IRAs don't include mandatory withdrawals. So if you don't need the money, you can leave it where it is, growing tax-free, instead of withdrawing it and being taxed on it. 401(k)s are not designed to be left to your loved ones -- but you can do so with a Roth.
- Roth IRAs won't hurt your Social Security situation. As Kathleen Pender explained in the San Francisco Chronicle recently, "When you begin drawing Social Security, you may have to pay tax on some of your benefits if your income is high enough. Money you take out of a 401(k) increases your income and can increase the tax you pay on Social Security benefits."
Are there downsides to Roth IRAs? Of course. While you can contribute up to $14,000 (or $18,000 if you're 50 or older) to a 401(k) plan, you can contribute only $4,000 per year (or $4,500 if you're 50 or beyond) to an IRA. Also, as Pender pointed out, you can often borrow money from your 401(k) plan, while you can't do so with Roth IRAs. And perhaps most importantly, 401(k)s often come with matching funds from your employer, while Roth IRAs don't. If your employer matches any money you plunk into your 401(k), by all means get as much of that matching as possible, because it's free money.
The bottom line is that you should take some time to learn more and assess your situation. You can learn a lot in our IRA Center and our 401(k) nook. Learn about this new beast, too: The Roth 401(k).
The best route might be using both your 401(k) and a Roth IRA, and perhaps some other vehicles, too. Get helpful tips in our Rule Your Retirement newsletter, and consider trying our TMF Money Advisor financial planning service, too. It's inexpensive, it offers personal, professional advice via phone, and you can try it for free.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.
