I know that eating wild Pacific salmon is good for me, and that Atlantic salmon can contain more dangerous contaminants than Pacific salmon. But I crave more information. For example, given a cheeseburger and Atlantic salmon, am I better off with the fish? These kinds of quandaries can arise when trying to choose a retirement account.
You probably know that IRAs are good for you, helping to secure a comfy retirement where you can afford to eat Pacific salmon. And you know that it's good to take advantage of your employer's 401(k) plan, too. But there are two main kinds of IRAs, and lots of other kinds of plans as well. Given all these options, where should you park your hard-earned dollars first? Here's one take, ranking which accounts to max out first:
- Company-sponsored 401(k) with matching funds
- Roth IRA
- Company-sponsored 401(k) with no matching funds or retirement plans for the self-employed
- Traditional IRA (if you don't qualify for a Roth)
- Regular brokerage account
Your priority should usually be your employer's 401(k) plan, if it matches your donations to any degree. Take maximum advantage of matching funds, because they represent free money which will grow for you over time. The Roth IRA is the next best option for most people, since it offers a place where your (post-tax) dollars can grow tax-free for many years. Note that you're probably best off contributing as much to your 401(k) as you need to for the maximum match, then putting your next dollars into a Roth IRA. Once you've maxed out the Roth, look at the 401(k) again, and after that, a traditional IRA.
To appreciate what the Roth can do, imagine that you were smart enough to invest in Genentech (NYSE:DNA) 10 years ago, parking $10,000 into it via your Roth IRA. It would have grown by a compound annual growth rate of 28%, becoming more than $120,000. If this had been in your regular brokerage account, you'd be looking at capital gains of $110,000, which at a tax rate of 15% would cost you $16,500. In the Roth, all that gain is tax-free.
Here are a few more advantages of Roth IRAs, from Robert Brokamp, editor of our Rule Your Retirement newsletter:
- Assets in an employer-sponsored plan (and in a traditional IRA, for that matter) must start being distributed by the time the account owner turns age 70 1/2, whether the money is needed or not. Thus, the account owner loses the benefit of tax deferral on that money, and the withdrawals may move her to a higher tax bracket. However, there is no required distribution age for assets in a Roth IRA. If the money is not needed, it can continue to bask in the glow of tax-free growth.
- Withdrawals from work plans and traditional IRAs before the account owner is age 59 1/2 result in immediate taxation and a 10% penalty. Some plans allow participants to borrow from their plans, but many don't. On the other hand, contributions to a Roth IRA may be withdrawn anytime, penalty- and tax-free. The same can be said of earnings withdrawn for first-time home purchases, as long as the money has been in the account for at least five tax years. Not that we recommend this, but if you need the money, it's there.
Of course, everyone's situation is different. All this advice isn't absolutely the best for absolutely everyone, since there are many variables. For one thing, if your 401(k) plan only gives you a selection of mediocre mutual funds in which to invest, you might not want to max it out. In IRAs, you can invest in just about any stock or fund. If, for example, you're psyched about Abercombie & Fitch's (NYSE:ANF) new store concepts, and you'd like to invest some of your retirement in them, 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 Cisco Systems (NASDAQ:CSCO) -- read Tom Taulli on its forays into security -- you can invest in that, 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.
So what should you do? Begin your decision process by visiting our IRA Center.
Learn more in our 401(k) nook, and in these articles:
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. The Motley Fool has a full disclosure policy.
