When it's time to invest for retirement, things can get confusing. 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 decreases your taxable income, giving you a tax break up front. Through a 401(k) 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, you get to keep all that, paying no taxes. Nice, eh?
Here are some of the Roth IRA's other advantages over the 401(k):
- IRAs offer more options. You can open them through your bank, your brokerage (check out our Broker Center for IRA fees for several major brokerages), or 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 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.
Imagine, for example, that you (like Tim Beyers) believe in the future of TiVo
(NASDAQ:TIVO)because you see it soon raking in lots of advertising dollars. If you want to invest some of your retirement in it, you can't do so via a 401(k), but you can through a Roth IRA. If you like the long-term prospects of Intuit (NASDAQ:INTU)and are impressed with its rising return on invested capital, you can invest in it, too. And you can sell them 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. 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. While 401(k)s are not designed to be left to your loved ones, you can do just that with a Roth.
- Roth IRAs won't hurt your Social Security situation. As Kathleen Pender explained in the San Francisco Chronicle, "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 $15,000 (or $20,000 if you're 50 or older) to a 401(k) plan, you can contribute just $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, which Roth IRAs don't allow. 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 that's free money.
Take some time to learn more and assess your situation. You can learn much more in our IRA Center, which features info on the various kinds of IRAs, eligibility restrictions, and how to open an IRA. It even offers a comparison chart for IRA accounts at TD Ameritrade
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. TiVo is a Motley Fool Stock Advisor pick, while Intuit is a Motley Fool Inside Value selection. The Fool has a disclosure policy.