Confused by Retirement Accounts? Roth, Regular IRAs and 401(k)s Made Simple

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We talk a lot about putting aside retirement money in a 401(k) and IRA. But what does that really mean? Here are the basics of these common retirement plans, including whether to Roth or not.

At Money Talks News, we talk a lot about retirement.

We’ve told you how to retire rich, and we’ve told you how to retire poor. We’ve told you about the retirement mistakes you’re making, and we’ve even told you why retiring after age 66 may be a great idea.

But maybe you’ve read through those articles and felt a little lost with the acronyms and letters sprinkled in between all that talk of compound interest.

Confused? Don’t feel bad. The government doesn’t make anything easy. Just check out the IRS website’s page on retirement plans for proof. But for an easier-to-understand overview of common options, read on.

Roth IRA vs. traditional

First, let’s discuss the difference between regular and Roth IRA accounts and how to choose between them.

Traditional accounts are set up so your contributions are deductible. For example, if you put $5,000 into a traditional IRA, you get to deduct $5,000 from your income at tax time. When you retire, you pay taxes on the money as you withdraw it.

Traditional accounts require participants to begin withdrawing fixed amounts, known as required minimum distributions, or RMDs, by age 70½. The RMD depends on the owner’s age and value of the account. Failure to take the minimum distribution can result in hefty fines.

Roth accounts are relatively new. They are named in honor of U.S. Sen. William Roth, who helped usher them in as part of the Taxpayer Relief Act of 1997.

Roths are a mirror image of regular retirement plans. With a Roth account, you don’t get a deduction, but you don’t have to pay taxes on your withdrawals in retirement. By skipping the tax break during your working years, you get tax-free money when you take it out. And there are no RMD requirements with Roth accounts.

Picking the right account

Consider that $5,000 you deposited, and assume it’s grown to $50,000 by the time you retire. With a Roth, you’ll have paid taxes on the $5,000 you originally deposited, but you’ll pay nothing on the rest. With a traditional account you’ll pay taxes on the entire $50,000. Now you see the appeal of the Roth.

However, using a Roth also means missing out on lots of potential tax deductions during your working years. The math is complicated, but a report from T. Rowe Price finds that putting money in a Roth IRA almost always gives you more disposable income in retirement than the same amount deposited in a traditional IRA.

According to that analysis, the only time it may make financial sense to use a regular account is if you are over age 50. Even then, a traditional IRA gives you more money only if your tax rate drops by about 9 percent once you reach retirement.

There are tons of online calculators that can help you decide which way to go. Simply do a search for “Roth vs. traditional calculator.”

Now, let’s consider two of the most common plans used for retirement.

401(k) plans

When traditional pensions were shown the door by employers, many companies replaced their defined benefit plans with 401(k)s. The name comes from the applicable section of tax code.

Many for-profit companies offer 401(k) plans. Similar options, 403(b) and 457(b) plans, are offered by nonprofit and state and local government employers, respectively.

Employer matching funds: Some employers will put a set amount of money into your 401(k) — say, 3 percent of your annual income. You can also make your own contributions, and many employers will match a portion of the amount you deposit.

For example, an employer might match dollar for dollar your contribution up to an amount equal to 3 percent of your annual income. Or they may match 50 cents of each dollar, up to 6 percent of your income.

The percentage and match amounts, if any, are up to your employer. But if your employer offers a match, you want to contribute whatever it takes to pick up the maximum match. Otherwise, you’re leaving free money on the table.

Another consideration: You may need to work at your employer for a certain length of time to become vested — that is, to get access to all the money your employer is contributing on your behalf.

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