Young Investor: IRA, 401K Or Roth?
Young people should be thinking about their retirement as soon as they graduate from college. Putting money away for retirement should start as soon as you get that first paycheck. The typical savings vehicles are the IRA, the 401k and the Roth IRA. Which savings plan is the best one for you?
The Traditional IRA offers you an immediate tax savings. Instead of paying tax on the income when you contribute, you are taxed on that income when you withdraw it during retirement. You also have the option of converting your Traditional IRA into a Roth IRA at any time. Keep in mind that you cannot convert a Roth IRA into a Traditional IRA.
A Traditional IRA has a forced distribution age attached to it. At age 70, you must start withdrawing your money. There is also a 10 percent penalty levied on any withdrawal made before age 59 and a half with few exceptions. The amount of your early withdrawal may also have to be added to your taxable income for the year.
The biggest advantage of the Roth IRA is the way it is structured. You can take out any principal without paying income taxes or any other penalty. Another huge advantage is that you can use that money to pay for your principal residence without having to pay tax on that money. This means that you can borrow up to $10,000 to purchase a home without any penalty. If you die, your spouse gets your money without any strings attached.
The money is not tax deductible. This means that you have to pay income tax on any funds that you contribute during a given tax year. There are also income limits in regards to how much you can borrow. If you make too much money, you are not able to contribute as much.
A 401K is an employer sponsored savings plan. You are allowed to contribute funds with pre-tax dollars. This gives you a significant tax advantage as soon as you contribute. Employers will match a certain percentage of your contribution as well. Generally, the match is 3-5 percent of your contribution. This money will accrue compounding interest as long as it is in your account.
Much like with a Traditional IRA, you are subject to penalties if you withdraw before age 59 and a half. On top of normal income taxes, you will be charged a 10 percent penalty. Unlike a Traditional IRA, there are fewer exceptions to this rule.
Employers have a lot of leeway when it comes to including or excluding these exceptions from their 401K offering. Another negative aspect of the 401K to think about is the force out clause.
Your 401K can be closed if the balance is too low if you are no longer employed with the company where your account was set up. To avoid this, you may need to rollover your 401K when you switch employers.
Knowing where to put your retirement savings is important. You need to know the pros and cons of each savings vehicle. Sitting down with a financial adviser can help you make sense of your options and how you should proceed.