Which Retirement Account Should I Open?
A retirement account is a savings plan set up specifically for your future retirement. These accounts defer the payment of income tax on the money in the plan. Some plans allow you to prepay your tax in exchange for tax-free income. But, what plan should you choose? You need to understand how the most common plans work and then base your decision on your financial goals.
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Traditional 401k
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Traditional 401k plans are retirement accounts that are part of an employer's benefit package. You may only contribute to these plans if your employer offers the plan to you as an employee. Contributions are made on a pretax basis. Your employer may or may not match your contributions in the plan. You invest the money in mutual funds or other investments that your employer has allowed in the plan. When you retire, you take withdrawals and pay income tax on the money withdrawn. These plans are ideal when you want the opportunity to receive matching contributions from an employer and you think your tax rate will be the same or lower when you retire.
Roth 401k
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A Roth plan works similar to the traditional 401k in that it is an employer plan. Your employer may make matching contributions, but all contributions are made after-tax. Like the traditional plan, you invest in a variety of investments in the plan. Withdrawals from the plan are income tax-free during retirement. This plan is ideal when you think your future tax rate will be higher than your current one and you expect to pay more in taxes later.
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Traditional IRA
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A traditional IRA is an Individual Retirement Account. This plan allows you to make tax deductible contributions. You make the contribution during the year and then write off that contribution when you do your taxes. Like the traditional 401k, you pay income taxes on the money you withdraw. This plan is best when you want to have a retirement plan, but your employer doesn't offer one or when you want to have your retirement savings separate from your employer.
Roth IRA
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A Roth IRA accepts non-deductible contributions only. Then, withdrawals during retirement are income tax-free. This plan is ideal when you want to have the benefits of the Roth 401k, but you don't want your plan tied to your employer. You may also use the Roth IRA as a way to access some of your money before retirement. All other retirement plans restrict access to your funds except for certain emergency situations or exceptions. The Roth allows you to remove your contributions at any time without a penalty and without paying any tax.
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