Where Should I Invest?
Should your money go into a 401k or IRA? The problem with answering this question is, of course, that everyone's income is different, but we can look at how these options work, and how to give yourself the advantages they offer for your retirement.
How does a 401k and IRA work?
A 401k from the company you work at will hopefully offer you a company match. The amount they contribute varies from company to company, but basically how it works is that if your company will match two percent of your income, and you set your account to contribute that much, the company will also contribute two percent to your account. This is free money. This money is then invested. With a 401k you are given a few plan options to invest in, so you can only invest in the plans your company offers. This is nice for people who like having this easily set up for them, but some prefer to pick their own stocks and want more control over their options. The money for your 401k is taken before taxes and is tax deductible. This money will be taxed when you withdraw at retirement age. You can not withdraw money until you are 59 years and 6 months old, if you try to withdraw sooner you will have to pay large penalties.
There are two main types of IRAs (Independent Retirement Accounts), a traditional or a Roth.
A Traditional IRA is, as the name suggests, is done independently of your company. Because this is done independently you have more control over your account and are responsible for figuring out how to invest, which you can ask a professional for help with. These are fully or partially tax deductible, depending on your situation. The money is deposited before taxes. When you are 59 years and six months old and begin withdrawing your withdrawals will be taxed. If you withdraw early you will have to pay heavy penalties.
A Roth IRA is similar to a traditional in many ways. It is done independently so you have a lot of control over the account. However, a Roth account is not tax deductible, and the money you deposit is after taxes. Because of this you will be able to withdraw from the account tax free in retirement.
401k and IRA Contribution Limits
The 2009 401k and IRA contribution limits are as follows:
401k | $16,500 | $5,500 catch up
IRA | $5,000 | $1,000 catch up
You can contribute more to your accounts, but they will not be tax deductible. The catch up amounts are for those who are over 50 years old.
How do I decide to invest in my 401k or IRA?
As I said in the beginning, everyone's situation is different and this is an individual decision.
The first important factor to consider is the company match on your 401k. If you don't take advantage of this you are missing out, as you won't be seeing that money elsewhere.
The next consideration is lowering your annual gross income to lower your tax bracket. If you invest in a 401k or traditional IRA you are lowering your income level because your contributions are tax deductible, with a Roth they are not.
And the last, and very important, consideration is your tax obligations in retirement. With a 401k or traditional IRA your withdrawals will be taxed in retirement, a Roth IRA is made up of after taxes money so your future withdrawals are tax free. So, the question to ask yourself is, what will your future income tax rate be? If your rate is lower now than you expect it to be later because of a lower income level, then you should take advantage of your current low rate by using a Roth IRA.
Of course, how do you really know what your income will be at any point in the future? To cover all circumstances, and to vary your tax obligations in retirement, use both a 401k and Roth IRA.
One popular option is to contribute to your 401k up to the company match and then the Roth IRA up to the the limit. If you have more money to invest once that is taken care of, raise the 401k contribution.
Of course, if you are trying to lower your current income bracket or have other goals there are many other ways you can handle this. To make sure you are using your 401k and IRA to your best advantage contact a financial professional.