Mutual Fun(d) Decisions: Part 3, IRA What?

Happy [belated] 4^th of July, Readers!

In honor of Independence Day, today, we’ll take a reader question, one that I’m sure more than one person out there has:

Dear Stock Market Chic,

Thank you so much for the great insights! My investing life will never be the same! Anyway, I know you’ve talked in previous posts about 401Ks, but I’ve also heard of IRAs and Roth IRAs. What’s the difference?

Signed,

IRA, what?

 

Dear IRA,

Thanks for your question! With so many different investment account acronyms out there, it can be confusing to get them all sorted, so it’s a great question.

A 401K is a retirement savings account sponsored by your employer. Money may be taken from your paycheck pre-tax to help fund it, and the percentage you want to contribute is typically up to you. Some employers require a certain amount; others don’t. Either way, you should save as much as you can. Generally, your employer will match your savings with a certain percentage contribution, too, but those funds may be off limits until the “vesting period” is over; that is, you might have to stay with your employer for a certain amount of time in order to actually get their end of the contribution.

 

There are limits to how much you can contribute in a year, though. The cut-off varies year to year, but is normally somewhere between $15,000 and$17,000, which is a lot to set aside anyway. You decide how to invest your 401K assets, and none of it is taxed until you take it out of the account. BUT there is a 10% penalty tax if you take the money out of the account before you’re 59 ½ years old, on top of the income tax you’d get socked with (there are some legitimate reasons to not get penalized, though, but they are few and far between). So, to that end, leave your 401K there until you’re ready to retire, or roll it over into an IRA.

For more info on 401Ks, click here.

An IRA, or individual retirement account, is another type of retirement savings account, but is not associated with an employer. You can open an IRA at your local bank or credit union. This account is commonly known as a “traditional” IRA, as opposed to a Roth, which we’ll discuss in the next section. The biggest thing to know about traditional IRAs is that they are tax deferred, so you don’t pay any tax on contributions now, but you will when you withdrawal the funds during retirement.

Let’s say you have a 401K at your current job, but you plan to change jobs soon. You can either keep the 401K where it is or you can roll it over into an IRA. The latter option allows you to keep contributing to it, tax-deferred. The more you can shove into a traditional IRA or 401K now, the lower your taxable income will be, but contribution limits are considerably lower for IRAs, so don’t think you’re getting over on the IRS. In 2013, it’s $5,500 ($6,500 if you’re over 50).

For more info on traditional IRAs, click here.

A Roth IRA is almost the exact same thing as a traditional IRA, except that you contribute to it with after-tax income. Since you’re paying The Man now, you don’t have to pay him in the future! You might still be subject to a penalty when you withdrawal the funds, though, depending on your reason for taking the money out.

That said, there are strict income limits on Roth contributions, but most people qualify easily. Maximum contribution also has a bit of a low ceiling, at $5,000, but you can contribute to a Roth even after you’re retired.

For more info on Roths, click here.

I hope that clears things up a bit! I’m happy to take more questions!

Wishing you rich returns,

Vonetta