Roth IRA vs Traditional IRAs vs 401K

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Saving for retirement is an excellent objective. Congress has created tax incentives to allow you to get a tax benefit on your savings. One example is an IRA, a 401K or other qualified retirement account. But what is a Roth IRA? Is it better than a traditional IRA or not? The answer is that it depends. Do you want the tax deduction to reduce your taxes now or would you prefer to have a tax-free retirement account.

The traditional IRA has been around for thirty years or more. It gives you a tax deduction to reduce your tax bill or increase your refund. If you deposit $5,000 into a traditional IRA and depending on your tax bracket, your taxes are lowered by $750 or $1,250 or more. So you're out of pocket cost is only $4,250/$3,750 because you have saved the difference in taxes. This gives you more money in the account to make money while it also saves on your tax bill for the year. State taxes will be reduced in many cases.

A 401K is similar to a traditional IRA, but you can get this tax break for higher income levels, where you may not qualify for a traditional IRA. The way that I look at a 401k is that it reduces the income in the top or marginal tax bracket. Many employers match the employee's contribution. If you are looking at increasing your contribution to the company 401K, remember that your taxes will be lower because you have reduced the amount of income that you pay tax on. Depending on your tax bracket, for each 3% or 4% that you increase your 401K contribution, you can lower your federal (and state withholding) by a total of 1%. When you get a pay increase is an excellent time to increase your 401K contribution.

So what is a Roth IRA? For those that qualify, it is a non-deductible IRA for which the earnings are never taxed. There are income limits to the contributions so all persons do not qualify. This means that if you deposit $5,000 in a Roth IRA you pay the taxes on that money. For example, assume that this money grows to $20,000 over 20 years (assuming a 10% long term rate of growth), this money comes out TAX-FREE. You will pay tax on $5000 now as part of your other earnings and pull out $20,000 with no additional tax to pay at retirement. Some company 401K plans now allow for contributions to be designated as Roth contributions. Contribution limits on 401K contributions can also be higher than IRAs.

For higher income taxpayers, there is a non-deductible IRA for those who do not qualify for a traditional IRA or a Roth IRA. No deduction is allowed for the contribution. Tax on the earnings is tax-deferred. And when the money is withdrawn, tax is paid on only the earnings, not the entire distribution. The taxpayer is responsible for keeping track of the contributions over what may be twenty years or more. Although this type of IRA does not have the appeal of the traditional or the Roth IRAs, it can be useful in certain situation. In these cases, a 401K may be available through the employee to achieve tax advantaged retirement savings.

There is no one right answer as to whether a before-tax or an after-tax retirement contribution is best for your situation. It is something that should be discussed with your tax adviser to make sure that you get the best advantage when planning for retirement.

Phil Bailey is CPA - Your trusted tax adviser helping small businesses to comply with tax laws since Georgia since 1983. Please follow me on Twitter at www.twitter.com/epbaileycpa. For more information please visit at www.EPBaileyCPA.com

Phil Bailey is CPA - Your trusted tax adviser helping small businesses to comply with tax laws since Georgia since 1983. Please follow me on Twitter at www.twitter.com/epbaileycpa. For more information please visit www.EPBaileyCPA.com

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