A 401k is one of the best ways to begin building wealth at early age. The other? The Roth IRA. Like the 401k, if you start contributing to the Roth IRA at an early age, you will have a big ol’ chunk of change by the time you’re retirement ready.
The difference between the two types of retirement accounts? Remember how the money you contribute to your 401k is pre-taxed (which is what makes the 401k such a money-making machine), coming off the top of your paycheck? Well, the money you save in a Roth IRA is income that has already been taxed. Thus, you don’t have to pay any taxes when you withdraw it. You may remember that this is the downer with the 401k because your money gets to grow tax-free for decades, when you finally withdraw it, it’s slapped with taxes.
From what I have found, this seems to be what makes the Roth IRA a better deal than the 401k. Both are plans that allow your money to grow tax-free, however, because the money you put into the Roth IRA is after-taxes, you don’t have to pay any money upon withdrawal, a time when you’ll likely have more assets. Having more assets means you’d have to fork over more money in taxes upon withdrawal. By saving part of your already-taxed income into mutual funds, stocks, bonds, or whatever investments your heart desires, it gets to grow rapidly and you won’t have to pay taxes on it when you take the money out.
One very important thing to note. If your company has a 401k match, meaning they contribute money to your 401k as you contribute money to your 401k (yes, true story) your company may give you money for your retirement—then a 401k is definitely, absolutely, the best choice. If your company matches your 401k contributions, make sure you max out the amount they match prior to opening a Roth IRA.
Back to the Roth. Ramit Sethi, of IWillTeachYouToBeRich.com, made the benefits of the Roth IRA crystal clear in an article called “The World’s Easiest Guide to Understanding Retirement Accounts” (you can bet I liked this guide) when he wrote:
Here’s how it works: When you make money every year, you have to pay taxes on it. With a Roth, you take this after-tax money, invest it, and pay no taxes when you withdraw it. If Roth IRAs had been around in 1970 and you’d invested $10,000 in Southwest Airlines, you’d only have had to pay taxes on the initial $10,000 income. When you withdrew the money 30 years later, you wouldn’t have had to pay any taxes on it. Oh, and by the way, your $10,000 would have turned into $10 million.
Think about it. You pay taxes on the initial amount, but not the earnings. And over thirty years, that is a stunningly good deal.
NoCreditNeeded.com posted a very short article titled “A Fully-Funded Roth IRA At Age 18 Could Net You 3.5 Million Dollars” with a very convincing graph that will help you visualize the benefits.
Now of course there are exceptions. If you make more than $95,000 a year, you’re not eligible for a Roth IRA. The maximum you are allowed to contribute in 2008 is $5,000 if you’re forty-nine or younger, and $6,000 for people aged fifty and above. It’s a very smart idea to max this out (meaning contribute the whole $5,000), but if you can’t, every dollar still counts.
As Ramit put it, “Even waiting two years can cost you tens of thousands of dollars … don’t care where you get the money, but get it. Put it in your Roth and max it out this year. These early years are too important to be lazy.”
And yes, I recognize that talking about investing at a time of economic turmoil may sound foolhardy, but remember—this is your retirement money. The magic of dollar-cost averaging means that when the market is down, such as now, you’re able to get more for your investing dollar.