While a 401k is probably the most popular and well-known type of retirement account, there are a few others you may have heard about. In this article, you will learn what a Roth IRA is, and how it’s tax-favored status can be leveraged by investors at any income level. A Roth IRA is the only investment vehicle that allows you to withdraw gains and dividends completely tax-free. For that reason alone, it is one of the most valuable diversification tools in a strong retirement account.
The Basics: 401k vs. Roth IRA
- A 401k plan allows you to make pre-tax(deductible) contributions that will reduce your Adjusted Gross Income(AGI).
- The yearly employee contribution limit on a 401k is $17,000.
Many companies will percentage match(up to 4 or 8% for example) on contributions the employee makes to their 401k. At a minimum, you should contribute up to the company percentage match. However, I like to use the rule of 5 for 401k contributions. You take the first 2(or 3 if you’re in six figures) numbers of your salary and divide by 5. Example:
If you make 50,000: take 50/5 = 10% 401k Contribution
- Contributions to a Roth IRA are not tax deductible but they may be withdrawn at any time for any reason.
- Any gains above principal can also be withdrawn tax free after the age of 59 1/2.
- You can contribute up to $5,000 per year as long as your AGI is less than $122,000.
There are a couple other restrictions and rules, but generally these will not apply. More detailed information about Roth IRA’s can be found here.
Why I love the Roth IRA
The key to a successful investment portfolio is diversity. Diversity can be easily achieved by holding mixed asset classes; but it is also important to diversify from a tax perspective. Deferring taxes on 401k contributions means you will still have to pay taxes at ordinary income rates when you start withdrawing in retirement. If too much of your retirement nest egg is in your 401k, you could be paying taxes at the highest income tax rate on all 401k withdrawals. This assumes that you have other sources of income: Social Security, rental income, etc. When you retire in 20-30 years, who knows what the tax rate will be; but at one point in 1945, the highest federal tax rate was 94%! Although it’s very doubtful rates will return to this peak the Roth IRA allows us to diversify for a future scenario with much higher tax rates.
Who should use it
Anyone under the $122,000 income limit is free to contribute to a Roth IRA as long as they have earned income. There is even a legal way for those over the income limit to contribute known as a backdoor Roth IRA(send me an article request if interested in this option).
When to use it
You can still contribute to your 2011 Roth IRA up until April 17th(Federal tax filing deadline). Roth IRA contributions can always be made for the previous year up until the federal tax filing deadline. And remember, the maximum is $5,000; so any amount up to that will go a long way towards securing your finances.
Do you think a Roth IRA makes sense? Do you expect your income to go up in the future? What about tax rates, are they on the upward trend?
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