A bit about IRA's

We left off discussing pensions with the concept of using IRA's to save on your own instead of in a 401K. Let me start by reemphasizing the benefits of a 401K over an IRA. Four important things come to mind although there are more.

First and perhaps most importantly, is to contribute as much as possible to get the maximum match from your employer. Never turn down "free money" ok? Second, you can save larger amounts in a 401K than in an IRA regardless of income (provided you aren't in a special class of employees at the company- a problem that is unlikely unless you make big bucks at a very small firm). Third, the maximum 401K employee contribution is $15,500 compared to just $5,000 in an IRA. Fourth, the 401K contribution is deductible in full, while the IRA contribution may not be.

Say you aren't offered a plan through work, want to save even more or want to contribute more on behalf of a non-employed spouse. This is where IRA's come in. An IRA (individual retirement account) is an arrangement where you may be entitled to a tax deduction for contributing and there are no taxes on the income or capital gains until the money comes out. This latter condition, no taxes on earnings or gains, is called "tax deferral". Just like with a 401K, you can use the double tax benefit to compound funds faster than otherwise. (The deduction for contributing depends on a number of factors including your income and plan availability through your employer. For full details, see publication 590 from the IRS).

Naturally, Congress doesn't make it easy, so there are two types of IRA's, the "Roth" and the "Traditional". The traditional IRA allows you to contribute and take the deduction like I mentioned above. Sometimes it is referred to as a "contributory IRA" because you contribute to it. The Roth IRA on the hand is a true gem in the right situation. Similar to the others, a Roth provides for tax deferral of gains and income, but does not allow a contribution to be deducted. So why is it a gem? When you retire (after age 59.5), money comes out of a Roth entirely tax free. That's right- no capital gains, no income taxes. What's the catch? If you make too much money, you can not contribute to a Roth. For 2008, if you are married and earn more than $159,000 (AGI), the ability to contribute disappears.

Here comes the interesting tradeoff between a Roth and a contributory IRA: You might think that if you don't make that much, it would be wise to take the deduction now because you could use the money. However, consider that if you don't earn much, your tax bracket is relatively low which means the benefit of the deduction is small. Say you are in the 15% tax bracket and contribute $5000, you would get a tax break of $750. That $5,000 grows at 8% for 25 years and becomes $34,242 which you then want to take out. You must pay income taxes (not capital gains) on the whole withdrawal ("distribution"). If you are in the same tax bracket, the net result is the same, but if your tax rate is higher when the money comes out, a Roth is better. It is a situational decision made with considerable uncertainty. However, you can contribute to your 401K and a Roth (if you don't earn too much) and hedge your bets.

Think of it this way, you can lower your tax bill today by contributing to the 401K and lower it in retirement by using the Roth also. Of course that means you actually have to save instead spend, spend, spend- which ties right back to the earlier article on disappearing pensions. As pensions disappear, workers are assuming a greater role in providing for their own future whether they like it or not. That means burying your head in the sand and calling ‘hope' a strategy isn't likely to pay off. The Long Run Blog readers know better, so tell your friends why they need to save.