Financial Planning

When most people think about retirement savings, they think of either social security or a 401(k). 401(k)s are a great option because they allow you to fund your retirement with pretax dollars, which means it gets to grow before Uncle Sam takes his cut. As to social security…well, if you’re expecting it to fund your retirement and you’re not over 50, you have more faith in the system than I do.

So if 401(k)s are so great, why bother with anything else? The main problem with the 401(k) is that the money is taxed when you withdraw it (and you’re forced to start withdrawing it once you’re old enough). This is a fair tradeoff – after all, you weren’t taxed on the money to begin with, and you got to (hopefully) earn a lot of interest on what the government would otherwise have taken.

However, what if you’re in a high tax bracket when you retire? I know I plan to be making a lot more 35 years from now than I am today; it hardly makes sense to avoid paying a low tax rate now so that I can pay more later! This is the situation that Roth IRAs were created for. The Roth is funded with after-tax dollars, but then it grows tax-free; if I put $10,000 into an investment inside of a Roth this year and it grows to a million dollars before I retire, I don’t have to pay taxes on a penny of that money. Good deal, no?

While you should never withdraw money from your retirement account before you actually retire, in an emergency it’s much easier to take money out of the Roth. The rules say that you can withdraw up to the amount that you put into the account for any reason whatsoever without paying a tax penalty; it’s only the earnings that you can’t touch. With a 401(k), on the other hand, early withdrawal could hit you with a big tax bill.

Roth IRAs and 401(k)s are created for different circumstances, but if you have a number of years to go before retirement and aren’t a high earner, the Roth probably makes more sense. Save on your taxes. Get a Roth! Check out my gold IRA article.

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