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Personal Finances / A Fool's view of IRA&401K taxes

URL:  http://boards.fool.com/kkch3n-you-wrote-ive-done-my-best-to-understand-29428150.aspx

Subject:  Re: Invest $1500 now or wait for IRA/Car? Date:  7/21/2011  4:21 PM
Author:  joelcorley Number:  199 of 201

kkch3n,

You wrote, I've done my best to understand IRAs, but...I don't get them sometimes.

What I thought was that I get a 401k and can denote that as a Roth or Tradiitional IRA? Or, can I get a 401k and a Roth?


"Roth" and "Traditional" refer to the type of tax treatment applied to the account. The term 401k refers to the section of the tax code that creates special tax treatment for employer-sponsored, defined contribution plans - which is a type of pension plan. (Traditional pension plans are known as "defined benefit plans" and have become almost extinct in private business.) An IRA is defined in a separate section of the tax code and must be opened by an individual - thus the term "Individual Retirement Account".

Traditional and Roth IRAs are both possible. I have both. But the tax code limits how much you can contribute in a year and how much of those contributions might be tax deductible (in the case of a Traditional IRA). Traditional and Roth 401k employer-sponsored plans are also possible, but the availability of either is entirely up to your employer. Roth IRAs were available first, but Roth 401ks have been around for several years as well. Also Roth 401ks are becoming increasingly popular, so there is a good chance your employer may offer you that option.

There are benefits and problems with both types of IRA and 401k plans. The advantage of a Traditional plan (401k or IRA) is that you can reduce your tax burden for the current year. This means your taxable income will be reduced and your tax savings will be taken from the highest tax bracket you happen to be in. You pay taxes on this money in the year you withdraw it. Roth plans (401k and IRA) have the same contribution limits as Traditional plans, but you get to pay the taxes the year you make the contribution. This has the advantage that you might be able to "stuff" the account with an additional 25-33%. You owe no taxes on withdrawals from a Roth plan as long as you meet the restrictions on withdrawing earnings.

Whether to contribute to a Roth or Traditional plan depends in large part on what tax bracket you think you'll be in when you retire. Since that partly depends on Congress and partly on your investment performance, it's difficult to hazard an educated guess as to which is the right choice. However, contributing to a Roth is usually the smarter option in your earlier years because your tax bracket is likely to only rise from here.

Also, Through the IRA, I could invest in stocks as I normally would through a brokerage? If that's the case, I might save most of my money until I start my job.

An IRA is a type of account that infers special tax treatment under the US tax code. Lots of financial institutions offer them - banks, insurance companies, mutual fund companies and yes, stock brokers. If you want to buy stocks directly in your IRA account, you can do that - you just need to apply for an IRA with a broker. Almost every broker offers Traditional and Roth IRAs, so your primary selection criteria probably has to do with other things like transaction costs, maintenance fees and customer service. I would suggest you look for an online review of brokers to see what they say about those options. Also there is a TMF board on the topic as well - try asking opinions once you've narrowed down the selection a bit.

- Joel
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