When saving for retirement, clients often ask about the difference between a 401(k) plan and a Roth IRA. Here is a quick outline about the potential drawbacks and benefits of each:
One of the main attractions of a 401(k) plan is deferred taxation on portions of your current income until retirement, when you will hopefully be in a lower tax bracket. The money that you put away, plus all of the growth on that money, may be taxed at a lower rate when you withdraw it. In theory, this will work out very well, as long as the government doesn’t raise taxes (a real possibility). One other HUGE benefit to employees who have a 401(k) plan is an employer matching provision. Many plans, although not all, offer employer matching on individual contributions. If this is the case where you work, you need to consider taking advantage of that benefit to the fullest extent. It’s free money! A five percent match means that you contribute five percent of your yearly income to the plan and your employer puts in five percent, too. It’s like getting a 100 percent annual return on your investment! I can’t stress this enough.
The Roth IRA is an individual retirement account that allows you to invest money after you’ve paid taxes on it. While you do not get to write off the amount you put into this account on your current taxes like you do a 401(k) contribution, funds in your Roth IRA grow tax-free. Once you retire, you get to withdraw qualified amounts and not pay taxes on it! The use of the Roth IRA as a retirement savings vehicle helps eliminate future tax policy as a variable. The government could raise the national income tax to 50 percent, but in theory, the money you withdraw as a qualified distribution will have no tax on it, whatsoever.
If you are faced with a choice between saving at work through your 401(k) plan or saving with a Roth IRA, here are some questions to ask yourself:
1. Does your employer match any portion of your 401(k) contribution?
If so, then put in at least up to the amount that they match (it’s free money!)
2. Do you think the government is likely to lower taxes in the future?
If not, you probably should start saving some money in a Roth IRA.
As always, these are very general rules and your own personal situation should be reviewed with a financial advisor. ♦
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