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

IRA Retirement Plans

While a 401(k) is the most popular plan, in second place is the IRA (Individual Retirement Account). This type of plan works very similarly to the 401(k) in that you contribute money towards it which will grow until you reach retirement. Again, it has the same penalty if you try to access it before you turn 59½.

One difference from the 401(k) is that it doesn’t need to be offered by your employer for you to use one. Instead, you can set up an IRA on your own.

Contribution limits

As of this year you can contribute;

  • Up to $5,500 to IRAs. And if you’re 50 years old or more, you can add $1,000 catch-up contributions.

This limit applies no matter how many IRAs you have. For example, you can’t place $5,500 in each, but $3,000 in one and $2,500 in the other.

Roth Vs. Traditional

Now, let’s get to the confusing part. There are two different types of 401(k)s and IRAs, traditional and Roth. So, what’s the difference?

Traditional plans are usually referred to as ‘regular’ plans. And Roths are actually quite new. They are named after William Roth Jr. This former senator passed a law that created Roth plans back in 1997.

The biggest difference between Roth and traditional plans is the way that they are taxed. With traditional accounts, you can invest pre-tax income. But, one of the perks is that when you add the money you can write it off as a tax deduction. This will lower your tax bill through your working life. However, when you start to withdraw the money, you’ll be taxed then instead.

With a Roth, it’s very similar except when you make contributions you won’t get a tax break. Instead, you’ll get tax-free withdrawals once you’ve retired. The main differences in terms of tax, between these two accounts are choosing when you’d prefer to pay tax.

What are Required Minimum Distributions (RMDs)?

If you’ve got a Traditional IRA then you will be required to withdraw more than the required minimum distribution each month, once you turn 70½ years old. The amount of the RMD is chosen by different factors like how much is capital in the account. If you decided to withdraw less than the RMD, you will be charged large fines.

But, Roth IRAs are not ruled by RMDs like Traditional accounts, giving them the edge. 401(k)s however, will be subject to RMDs at the age of 70½ if they are employer-sponsored.

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