How are IRAs and Roth 401(k)s Different?
As you plan for retirement, it is important to understand the differences between the various retirement savings accounts available to determine which one best suits your individual needs. Two types of accounts you may consider investing in are Roth 401(k)s and Individual Retirement Arrangements, or IRAs; each comes with different eligibility requirements and account restrictions. The key difference: You pay taxes on contributions to a Roth 401(k), but any withdrawals you take after age 59 1/2 are completely tax free. With an IRA, your contributions are generally tax deductible, but you will pay taxes on your withdrawals
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Individual Retirement Arrangements
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Traditional IRAs allow most investors to make tax deductible contributions, which then grow tax free inside the account until money is withdrawn. Once IRA money is withdrawn after age 59 1/2, it is taxed as regular income. Withdrawals between age 59 1/2 and 70 1/2 are optional, but you must begin taking withdrawals after age 70 1/2 whether you want to or not. Almost anyone can contribute to a Traditional IRA up to the annual limit, which changes frequently -- for 2011 and 2012, the limit is $5,000 or $6,000 if you're 50 or older. However, the tax deductibility of contributions may be limited by several factors. For example, married filers who are covered by a retirement plan at work lose their IRA deductions at $112,000 in 2012; for single filers who are covered, the cutoff is $68,000.
Roth 401(k)s
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Unlike an IRA, which anyone can set up on their own, a Roth 401(k) must be offered by an employer. Roth 401(k)s offer no tax deduction on your contributions. But once the money is inside the account, it grows tax free and all deductions taken after age 59 1/2 are tax free for life. The annual contribution limits to a 401(k) are much higher than the limits to an IRA: For 2012, the limit stands at $17,000, up from $16,500 in 2011. And anyone aged 50 and over can contribute an extra $5,500. Your ability to take advantage of a Roth 401(k) is not capped by income or age -- as long as your employer offers a Roth 401(k) plan, you can contribute to it. But, as with an IRA, you must begin taking minimum distributions from a Roth 401(k) once you reach age 70 1/2.
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Investment Options
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IRAs are almost completely self-directed, which means you can invest in almost anything you like inside an IRA account with the exception of such hard-to-value items as works of art. In a Roth 401(k), your options are limited to the investment options your employer provides.
Complications
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If you opt to invest in either a Roth 401(k) or a Traditional IRA, you should keep a few key points in mind:
Contributions: The contribution limits to IRAs and 401(k)s apply to all accounts of those types that you hold. In other words, if you have more than one IRA, your total contributions for the year to the multiple accounts cannot exceed your annual IRA limit of $5,000 or $6,000. The same is true of 401(k)s.
Employer matches: Employers cannot match your contributions to a personal IRA. They can match contributions to a Roth 401(k) up to a legal limit of 50 percent (individual plans may vary.) But the contributions -- which are tax deductible to both you and the employer -- must go into a separate Traditional 401(k) account. Employer matches do not count towards your annual 401(k) contribution limit.
Early withdrawals: With a few exceptions, withdrawals taken from a Traditional IRA before you turn 59 1/2 will face a 10 percent penalty plus income taxes. Withdrawals from a Roth 401(k) are less punishing in the sense that you can withdraw your contribution portion penalty free and tax free, regardless of your age, because you have already been taxed on that money. In other words, if you withdraw $1,000 from a Roth 401(k) at age 58 and 90 percent of your total account value has come from contributions rather than earnings, then $900 of the withdrawal will be penalty free and tax free, while you will pay a 10 percent penalty plus tax on $100.
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