401(k) vs. IRA vs. Roth: Choosing Which, When, and Why

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[dropcap]A[/dropcap]round tax-filing season, saving for retirement is probably more front-of-mind than than at other time of the year. After all, stuffing more in a retirement vehicle, such as a 401(k) or Individual Retirement Account (IRA) can reduce your current tax bill. But a recent Schwab survey found that more than half of Americans are perplexed about IRAs. The single biggest head-scratcher among those surveyed is what advantage there is to having both a 401(k) and an IRA.

If you’re one of the flummoxed, here’s a cheat-sheet on what you need to know about building a diversified retirement plan that takes advantage of both 401(k)s and IRAs:

The Basics

The case for 401(k): Both types of retirement savings options have unique advantages. With a 401(k) there’s often a matching contribution made by your employer. Getting an assist on socking away money for retirement is not to be missed. Another 401(k) advantage is the amount you can save each year. If you’ve yet to hit age 50 you can shovel up to $17,000 into a 401(k) this year; for the AARP crowd (50 and over) the limit is $22,000. That’s a lot more than the $5,000 annual contribution limit on an IRA ($6,000 if you’re at least 50 years old).

The case for IRA: But there’s still plenty to love about the IRA. One nice advantage is that you have incredible freedom to pick and choose the investments you want to own in your IRA. With a 401(k) you are stuck with the funds or ETFs offered by the plan. Hopefully that’s a lineup of smart low-cost options, but that’s not always the case. So if you happen to be stuck with a sub-par 401(k), adding an IRA into your retirement plan gives you the ability to invest up in stellar investments.

Which to Choose When Money Is Tight

Ideally you’ve got the flexibility to invest in both a 401(k) and an IRA. But let’s be real: you kinda feel, given your all your financial priorities, it’s an either/or. OK, here’s the game plan: If your employer offers a company matching contribution to the 401(k), make that your priority. And push yourself to contribute whatever is needed to earn the maximum match each year. If you’re not sure what that is, just check with HR on your firm’s matching formula.

Roth vs. Traditional IRA

IRAs come in two basic flavors: Traditional and Roth. The main difference is that with a traditional IRA you may be able to qualify for what is known as a deductible IRA: what you invest will reduce your tax bill for that year. Your money then grows tax deferred. When you make withdrawals in retirement that money will be taxed as ordinary income.

With a Roth IRA there’s no current-year tax break. But just like with a Traditional, your money grows tax-deferred during all the years it is invested. In retirement, all withdrawals made from a Roth are 100 percent tax-free. That’s the major difference: by forgoing an upfront tax break on your contribution a Roth payoff, tax free withdrawals in retirement come on the back end.

This year, an individual with modified adjusted gross income below $110,000 and a married couple that files a joint tax return with income below $173,000 can make a full investment in a Roth this year. Between $110,000 and $125,000 for single filers and $173,000 to $183,000 for joint filers you can make a reduced contribution. Above those upper limits you can still work your way into a Roth by first making a contribution to a Traditional IRA and then converting to a Roth. If you already have money saved in a Traditional, doing a Roth conversion can be a little tricky; it’s smart to consult with a tax advisor before making the move.

Making the Commitment

One hurdle with an IRA is that you and you alone must push yourself to get the money invested. Good intentions won’t make for a happy retirement. If you can afford to make an annual lump-sum investment into a Roth that’s great. But if you’re more likely to want to make smaller periodic investments throughout the year, then the smartest move is to set up an automatic monthly or quarterly withdrawal from a bank account into your IRA. Every IRA provider will be happy to do this for you for free. If that’s not something you’re likely to do, then maybe focusing on maxing out your 401(k) is best. That investment is totally automated as it comes out of each paycheck. At the end of the day, simply making sure you save for retirement, regardless of what specific type of account it is in, is going to have the biggest impact on helping you amass the money you will need to have a comfortable retirement.

More on the IRA dilemma on Daily Capital.

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Carla Fried

Carla Fried is a freelance journalist who has covered just about every nook and cranny of personal finance for media including Money Magazine, The New York Times, and CBS MoneyWatch.com. Prior to launching her own reporting and writing business in 2002 she was a senior writer at Money and the managing editor of Quicken.com.

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