Planning for your retirement: Traditional IRA vs Roth IRA vs 401k

Hi all,

I have been meaning to write this post for a couple of weeks now, but just haven't had the time. The idea came from a friend of mine (shout out to Mike!) who thought it would be helpful to learn a little bit more about the differences between Traditional and Roth IRA accounts. I'm going to do you one better and throw 401k's into the mix!

I want to try and keep this as simple as possible, so I'm going to start by describing the Traditional IRA account, and then use that as a basis for comparison to explain the differences with the other types of retirement accounts.

Traditional IRA:
The idea behind the Traditional IRA account is that a person can contribute money on a deferred tax basis each year. A deferred tax basis means that, although you will eventually have to pay taxes on this money, you won't have to pay them now. The money stays in the account until your retirement, during which time it has hopefully been growing. When it is time, the money is taxed as it is withdrawn from the IRA account. Here are some KEY bullets to help further explain:

• You can only contribute a maximum of some specified amount each year. This number is constantly changing but, in 2013, it was a maximum of $5500 ($6500 for people over the age of 50).
• Once money is contributed to the account, it cannot be cashed out until age 59.5, or else you will be charged a 10% penalty fee plus taxes. 
• While you cannot cash out before 59.5, you can use the contributed funds to buy and sell investments (stocks, bonds, mutual funds, etc.) within the IRA. This is how you can potentially grow your retirement savings!
• While in the IRA account, you will not need to pay any capital gains taxes on investment gains. 
• At age 59.5, you will be eligible to withdraw your savings from the IRA without paying any penalties. The money withdrawn will be taxed based on your current tax bracket. Typically, you will be in a lower tax bracket after retirement due to a decrease in income. This is so important!!!! It means that you could potentially be paying taxes on your savings at a lower rate than you would have at the time when you contributed those funds during the peak of your career. 

Phew! Okay so that is the gist of the Traditional IRA. Now lets use this basic understanding to help shed some light on the other options out there.

Roth IRA:

The Roth IRA account is very similar to the Traditional IRA. Here are the key differences:

• Roth contributions (same maximum of $5500 in 2013) are made AFTER tax, and are thus NOT tax deferred.
• Once contributed, you can withdraw money from a Roth IRA without paying any penalty fees like you would under a Traditional plan. 
• Money generated within the plan (such as interest or stock growth) is NEVER TAXED. With a traditional IRA, money is contributed before taxes, grows throughout your career, and then both the amount you contributed, plus any growth, is taxed when withdrawn. With a Roth IRA, money is taxed when earned, then contributed, and then never taxed again. 

And that's pretty much it! Biggest difference is the timing of when taxes are paid. 

401k Plans:

401k plans are also very similar to Traditional IRA accounts. Money is contributed on a deferred tax basis, it grows throughout your career untaxed (no capital gains taxes), and then it can be withdrawn after age 59.5 at which time it will be taxed based on your current tax bracket during retirement. Here are the big differences (there are a number of big ones so stick with me here!):

• 401k's have a higher maximum contribution (in 2013, the max was $17,500 per year, as opposed to the $5500 max for IRA's). This means that you have the potential to save even more money for your retirement.
• These plans are organized BY YOUR EMPLOYER, which has a couple of different ramifications:
• The employer will often match a percentage of the employee's contribution. Meaning, if you contribute $17,500 in 2013, your company may also contribute an additional percentage of that $17,500. 
• The employer can specify (read: limit) the investments available to the employee to build and grow their savings. For some people, this could be a really positive thing. For those of you that are really confident in your trading abilities, it may feel a little invasive.
• Contributions come directly from your paycheck. With an IRA account, you are taxed on your income. Then you deposit a portion of that money into the IRA, and you subsequently receive a tax credit on the amount contributed (thus "tax deferred"). With the 401k, you are saved the trouble, as the contributions come out of your paycheck before income is taxed. 
• Finally, you have the ability to BORROW MONEY from your 401k prior to age 59.5. You will still be charged a fee on the money withdrawn; however you will pay this fee in interest TO YOURSELF. You essentially borrow the money from your own retirement plan, and then pay it back with interest. 

Okay, so that is pretty much it. Couple quick notes: 401k's also come in the "Roth" variety. They are less common (a relatively new option), and are different from Traditional 401k's in the same ways that Roth IRA's are different from Traditional IRA's. In general, the 401k tends to be the more attractive option (higher contribution maximums, employee matching, ability to borrow); however, some people would prefer the IRA options simply for the freedom to invest in whatever they choose (as opposed to the limited options of an employer organized 401k).

Now, I think that was a pretty decent description of some of the key differences between the big retirement plan options out there, if I do say so myself. Having said that, simple descriptions will not (or at least, should not) be sufficient to make an investment decision. To help those of you faced with this issue, I have included several fantastic videos below, compliments of the Khan Academy. They really break down the nuances between the three big options, and demonstrate how they would affect your savings in practice. When I first signed my job offer and began taking a look at the big boy decisions I would soon need to make, I turned to Khan Academy to help clarify my options.

I hope you have all found this helpful! Let me know your thoughts.

Traditional IRA:

Roth IRA:

401k:

"Loans, Loans, Loans #womp," by Guest Blogger Ashley Sciora

If you’re reading this blog because you have some student loans weighing you down, welcome to the same boat that Anthony and I are in. Grab an oar, start paddling, and let’s talk about some ways to shed the debt!

Before you leave the safe space of your college or university, if you took out loans to pay for your education, you’ll have to sit through an exit interview to make sure you know the terms of loan repayment. If you’re me, this consists of frantically looking up your odds of winning the lottery and calculating how long a person can survive on pasta.  Had I paid a little more attention, I probably could have breathed a little easier knowing that there are options available.

Identify your loan holder

While the Department of Education may have a corner on the market, there are plenty of other entities who are willing to lend you money for school.  You can’t find out what options are available to you without figuring out who you have to pay back. Other common sources of loans: private banks and state departments of education.  Your school’s financial aid office should be able to help you with this.

When the grace period’s over…

Most, if not all, loans come with some sort of grace period; breathing room to figure out what your strategy is when the first payment request comes.  The federal government gives you six months, while other loan servicers may give you a shorter stretch of time.  The grace period is usually determined by the amount of time needed for the servicer to determine that you have graduated, won’t be re-enrolling in school and should be making payments.  A quick call to your loan servicer or a visit to their website’s FAQ section should help you make a timeline before repayment.

To Consolidate or Not Consolidate?

Most of us have multiple loans to our names when we graduate – whether your servicer granted a loan for a semester or a year or if you’re juggling multiple servicers, you’ll have multiple balances owed.  Consolidation will be the first option most of us consider.  The process of consolidation, if you’re eligible and the specifics of your arrangement will vary, but who cares about all that if you don’t know what consolidation means?  Consolidating your loans means that you’re essentially taking out another loan, equivalent to the balances on all of your eligible loans (you can only consolidate loans with the same servicer).  Consolidation is a much-talked about option, but may not be best for everyone.

Things to Consider:

• Decrease in monthly payment. It may be a marginal decrease, but in this economy, any little bit helps!
• Convenience. If you’re like me, you may get some piece of mind from only having to look at one balance and one statement per month (assuming you only have one servicer.)
• Change in interest rate. If I were to consolidate my student loans from my home state, the interest rate on the consolidated loan would be an average of my existing loans.  (Some of my loans had lower rates than others, that all gets factored into a new rate for the new loan.)
• Length of repayment. You’ll have longer to payback the consolidated loan, but that means more that you’ll end up paying in interest.
• Effect on deferment/forbearance options. Depending on your servicer, consolidating existing loans can have make you eligible for or disqualify you from some deferment or forbearance options.

Well, that's enough of that for now. The bottom line is not to panic! Educate yourself about your options and work out an appropriate repayment plan. Also, look out for a follow up post about loan discharge, forgiveness programs, and deferment/forbearance. Let us know about your thoughts and experiences with student loans in the comments!