The Amateur Financier

Welcome once again to the little corner of the blog where we discuss some of the greatest arguments in the personal finance world.  Today, we’ll discuss which is better when planning for your retirement, a traditional IRA or a Roth IRA.  (There are also traditional and Roth flavors of 401(k)s, as well, but since that choice will be made by your company and its human resources department, you’ll have less control over which variety you will have.)

The big difference between the two types of IRAs is when the the money you invest in them is taxed.  In traditional IRAs, the money you invest is taken from your taxable income, allowing you pay fewer taxes now, but the withdrawals when you retire are taxed at your regular tax rate.  Roth IRAs are funded with after-tax money and the withdrawals are tax-free.  The decision then becomes when you want to be taxed, now or when you retire.

Therefore, there’s a simple way to determine which type of IRA will be better for you: hop into your time machine, travel forward to the time you retire, and see what tax rates you will be paying.  If the rates are higher in the future than they are now, you’ll do best financially with a Roth; if the rates are lower (or if the Fair Tax has been enacted), than a traditional IRA is the way to go.  Then, come back to the present and open that style of IRA; easy as pie!

What’s that?  You don’t have a time machine?  That complicates matters a bit.  You can still choose the style of IRA you open based on what you think the future will hold for tax rates.  Personally, given the rising national debt and rather low current tax rates, I would imagine that tax rates are only going to rise in the future (although, again, the Fair Tax or other non-income taxes could drastically change the tax landscape), making Roth accounts more attractive.  Some other questions to ask yourself:

Will I need more or less money in retirement? – As a consequence of our graduated tax system, the less income you have, the lower taxes you pay as a percentage of your income.  Thus, since different IRAs allow you to be taxed at different times, you can attempt to determine how much money you will need to spend in retirement.  If you intend to cut down your spending when you retire, even just to the 70-80% of your final income that many experts say that you need, traditional IRAs should be beneficial; if you intend to maintain or increase your current level of spending, a Roth IRA will help you dodge the tax burden.

Do you want to lock in your tax rate? – One of the biggest advantages of a Roth is that you know what tax rate you are paying now (or at least, should be able to figure it out), and therefore know exactly what you are paying in taxes.  As we’ve already discussed, though, tax rates in the future are a big unknown.  If you prefer to pay your current tax rate and not have to worry about tax increases in the future, a Roth provides you with that opportunity.  On the other hand, if you are currently in a high tax bracket, taking a tax break now for your traditional IRA may make the most sense.

(If your taxable income is high enough, you may not even have the option of using a Roth.  For single filers, you can put in the  maximum ($5000)  if you earn less than $105,000 in 2009, with partial contributions allowed up to an income of $120,000; married couples filing jointly can donate up the max if they earn less than $166,000, and partial donations up to $176,000.  A complete matrix comparing income limits and other factors affecting traditional versus Roth IRAs and 401(k)s can be found here.)

Am I diversified? – Diversification isn’t just about holding a variety of investments, it also involves ensuring that your portfolio is prepared for whatever the tax rates do in the future.  If you have a traditional 401(k) at your work place, having a Roth IRA to help in case of rising taxes is a good way to diversify.  Similarly, if you are one of the lucky ones who has a Roth 401(k), having a traditional IRA can help to lower you current tax burden and help to minimize the taxes you will pay overall.

These questions, as well as your thoughts about how taxes will change in the future, will help you to decide which type of IRA will be best for you.  As is frequently the case, there is no easy answer to which type of account is better that applies to everyone equally, but hopefully, asking yourself questions about your tax rate, future spending, and the types of other accounts you hold will help you to make some good decisions.  Happy retirement planning!

Trying to decide whether you should invest in a 401(k) (or equivalent retirement plan)? It’s one of the most commonly suggested first steps for people trying to get their financial house in order; many financial advisers will tell you to contribute to your company retirement plan (at least, up to the maximum of any company provided matching contribution) before anything else, even paying down credit cards or building an emergency fund. But, is the decision really that clean-cut? Here are some considerations I’d make before asking Human Resources to add me to the plan:

Does my company provide a 401(k) to which I am eligible to contribute? This one’s pretty easy; if you don’t have a 401(k) plan at work (or you aren’t eligible for an account), you won’t be able to contribute. You might want to write to your HR representative or talk to your manager about adding it to your benefits, but until that happens, you’re just out of luck.

Does the company add matching funds to my contribution? The main incentive to invest through a retirement plan at work, rather than through an IRA, is that many companies will match your the amount of money you contribute with some portion of their own funds. So, if your company offers a 100% match on contributions up to 5% of your salary, then if you put 5% of your salary in the 401(k) plan, your company will add an equal amount of their own money to your account (in effect, you’ve doubled your money, without even trying).

It’s this employer match that drive the aforementioned financial advisers wild with desire for 401(k)s; they refer to it as ‘free money’, and admonish you for not contributing enough to your company plan in order to get the maximum amount possible. And, with few exceptions (which we’ll get to in a minute), they’re absolutely right.

Is the amount of money added by my company dependent on my contribution? This one’s based on my own experiences; my old company used to give all its employees a flat contribution each month ($200, half in funds according to our asset allocation, half in company stock). It didn’t matter if you contributed 3% or 30%, everyone still get the same amount of added company money. In this situation, the ‘free money’ afforded by 401(k) plans is given to you regardless, so you can focus on other priorities before your company plan.

If the answer to any of the above questions is no, you can put aside contributing to your 401(k), at least until you’ve done things like pay down your debt, max out a Roth IRA, and (especially if you, like me, aren’t yet in a home of your own and want to be) start saving for a house down-payment.

But these aren’t the only considerations when deciding whether (and how much) to invest in your company’s retirement plan. Here are two more issues to ponder:

Are your employer’s matching funds vested? Some companies that provide matching funds have a vesting period, where the company match is not immediately transferred to the employee. Instead, after a period of time spent with the company, the employer contributions will be transferred to the employees control. In this way, the company can hold out the promise of full vesting of the retirement contributions as an inducement for employees to stay.

If your company does vest its matching contributions, you have to ask yourself some serious questions about how long you intend to stay in the company, how long it will take for the matching funds to be fully vested, and whether it will be worth staying for several years in order to get the full amount of your company’s match. Depending on your personal situation, you might decide it is not worth contributing, especially if you expect to leave your position before you become fully vested.

Does your plan provide for decent investment options? Not excellent, not great, not even good; just decent. 401(k) plans are known for having higher fees and poorer selection (typically no more than a dozen investment options, if that) than IRAs or non-retirement investments. If you’re getting a good company match, that (and the tax deferment afforded to 401(k) plans) will more than compensate for the higher expenses, but you still have to have some decent investment options.

If you have a variety of mutual funds from a reputable fund family like Vanguard, Fidelity, or TIAA Cref, you should be able to find some useful funds amongst your investment options. You’ll still have to do some research in order to find the best funds for your asset allocation and fit them in along with your other investments, but at least you should the tools needed to build a decent investment plan.

If your plan doesn’t offer a decent selection of funds, if they force you to take your matching funds in company stock (and don’t provide the option of selling the shares at any time and reinvesting the proceeds) or invest in raw land, you should gather up your coworkers and DEMAND decent investment options.

For everyone else, look over your plan carefully, consider the investment options, and do what will help to maximize the money you can squeeze from your company’s tightly clenched fists.