Roth IRA

I just wanted to spend some time talking about Roth IRA since 2006’s last contribution date is coming up. You’ve probably heard of terms like 401K and IRA and then there’s traditional vs Roth and all being retirement accounts, and you’re thinking what is correct for you, what’s the difference, and so on.

To put into simple terms, 401K replaces pensions, and is a retirement investment account provided to you through your employer. You decide to put x% of your salary into this account each paycheck and so on. The 401K account I have also restricts me to what I can invest in to a limited set of funds and stocks, but I’m not sure if that is the same for every employer. When you changed jobs, I believe you stop contributing to your old 401K account and you create a new 401K account with your new employer. You do have the option to consolidate your old 401K account into your new one.

IRA on the other hand is a personal investment account, where you get to put in money whenever you want. It has no relationship with your employer. The deadline to invest for any particular year is the deadline to file your taxes. For the year 2006, the last day you can contribute to an IRA account is on April 17th, 2007.

The biggest difference between 401K and IRA besides 401K is tied to an employer and IRA isn’t, is the contribution limit. These limits change from year to year, but for 2006, 401K’s limit was at $15,000 and IRA’s limit was at $4,000. With IRA, you can decide after the fact if you want to contribute to it depending on your tax situation. With 401K, you have to consistently contribute and have to prepare beforehand on what you want to do.

Tax implications wise, there really isn’t much difference between 401K and IRA. What the difference lies is if it’s a Traditional or Roth. A traditional 401K or traditional IRA is where you contribute money (pre-taxed) and when you do take the money out, the full amount (original contribution + gain) will then be fully taxed. On the other hand, a Roth 401K or Roth IRA is fully taxed now, but when you take the money out, it will not get taxed again and neither will your gain.

Derek’s suggestion is to contribute to both Traditional and Roth retirement accounts because who knows what it’ll be like when you retire. Most people contribute into a Traditional account because they’re assuming when they retire, they won’t have a high income, so money they take out will be in the lower tax bracket. However, who knows what the tax situation will be like 40 years from now. If you have both Traditional and Roth accounts, you can withdraw accordingly. Take money out from the Traditional accounts if the tax is low. Take money out from the Roth accounts if the tax is high.

Anyway, after I got my tax refund this year, I decided I wanted to start my Roth IRA account. Another thing I researched on was penalty for early withdrawal. For Traditional accounts, since it’s only taxed when you withdraw, there are a bunch of fees and penalties for withdrawing early. However, with Roth accounts, you’ve already paid the tax, is there any early withdrawal penalty. Here’s a good example from The Motley Fool:

Jim, age 30, made a Roth IRA contribution of $2,000 in 1998. In 2005, Jim’s Roth IRA has a balance of $3,500. Jim decides to close his Roth IRA in a non-qualified distribution that year. Since the distribution is non-qualified, Jim will owe taxes on his Roth earnings of $1,500, and will pay tax on this amount at his marginal tax rate. In addition, since the distribution took place before Jim reached age 59 1/2, and since Jim did not meet any of the exceptions, Jim will also be assessed a 10% early withdrawal penalty on the earnings. If we assume that Jim is in the 28% marginal tax bracket, he will pay $420 in tax on the earnings, and will pay a penalty in the amount of $150 on the early distribution. This is a very steep price to pay.

In other words, I can withdraw early on the amount that I contributed without paying any fees/penalties. However if I early withdraw any of my earnings/gains, those will be taxed at my current tax bracket + an additional 10% early withdrawal penalty. I’m thinking, who the heck won’t invest in an Roth account then, especially Roth IRA since you don’t have to make a decision until April for the previous year. Another way to put this is that you’ll always have access to your principal, penalty free, which in most people’s case is all they’ll need. As long as you keep your earnings and gains inside your Roth account, there won’t be any penalty.

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