This weekend a family member was asking me about investing and asked me “which type of IRA is the best?” My answer was none of them. The reason I said that is because all of them have advantages and disadvantages and each could be the “best” depending on the individual’s needs. Here is a real quick run through of each type of investment account and my thoughts on them. This post is only for W2 employees who just want some simple advice. I am aware of other IRA’s but I won’t address those at this time. At the end of this post, I will discuss what I have elected to use. Remember this is just a blog, please see a CPA and tax planner to build an ideal strategy for yourself.

Traditional IRA
With a Traditional IRA, money is invested pre-tax (before tax) and therefore this reduces your taxable income. The idea here is that you get to invest you money now without being tax and then the government will tax you after you take the money out. Hopefully that number will be higher so you benefit from the larger account balance and the government gets to tax you on a higher amount. At the same time if you were to retire and therefore have a much lower income, the income tax rate you would pay could be lower. This is ideal situation is if you have a high income tax bill now but you expect to be in a lower tax bracket in retirement. The contribution amounts for 2009 (from IRS.gov) are $5,000 for anyone under the age of 50 at the end of 2009 and $6,000 for those 50 or older before 2010 assuming you qualify based on your income (check the irs.gov website). There is a lot more to go over but here is the main point: Main Advantage = Tax Deferral

Roth IRA
A Roth IRA is an account where money is invested after tax (so already paid taxes on it) and therefore the growth on the account is tax-free.  The benefit of course is that if you grow your money, you get to keep that money tax-free since you the paid the tax up front. With the stock market volatility recently that’s a big assumption but in the long term should work out.  The government is always in need of more money so they benefit from this plan as a dollar now is worth more than a dollar in the future. If you are in a low tax bracket and expect it to grow in the future than this is the plan for you. Another advantage that is commonly listed for Roth IRA’s is that contributions (NOT GAINS) can be withdrawn at any time. I would of course only use this provision under dire straits and that is why I try to avoid talking about it. Why give people the temptation? The contributions amounts for 2009 are the same for a Roth as they are for a Traditional but the income limitations are different. Please check those out and make sure you consult a professional to double check you do qualify. If you decide to do a Traditional IRA, you can not elect to do a Roth IRA.  Finally one common misconception about the Roth IRA is the belief that Congress will one day in the future decide to change the laws which will make gains on Roth IRA’s taxable. I just don’t see this happening. This would be a great way for a politician to get thrown out of office and so I think we are safe from this fate. So the Main Advantage for the Roth IRA: Tax-free Investment Growth!

401K
This is a plan typically set up by private businesses Roth IRA’s are a way to let employees invest tax deferred money which can be invested. There is a Roth 401k which is like the Roth IRA but again this is up to the employer and the more popular plan is the original 401k. With a 401k plan, contributions are made by electing a percentage of income that you want to be invested in the company 401k Retirement plan. This money is then put into the plan and depending on your custodian (vanguard, fidelity, ING etc) that will determine what investment options you may have. Some plans have 5 choices: Cash, Bond fund, Large Cap Stock Fund, Mid & Small Cap Stock fund and International Stock Fund. That’s it but some allow you to buy everything under the sun. It just depends on the company plan and if you are like most employees, you may have no real say except maybe complaining to the HR/401k Administrator at work (which at my job does nothing!). One benefit for the 401k is the fact that it’s pretty simple to enroll in a company plan. At my job I just put down the percentage I wanted invested per paycheck, sign, and I am all done. It also is a way to invest without self sabotaging and saying “oh I will invest later once I pay…”. Once the plan is started, the money is automatically taken out of your paycheck. Out of sight and out of mind! Finally another benefit is the fact that the money is tax deferred like an IRA but unlike an IRA the contribution limits are $15,500 for 2008 and $16,500 for 2009. This is about 3 times as much as you can put in a IRA! I saved the most important advantage for last: COMPANY MATCHING! Most companies provide some type of matching of employee contributions. Typically I have seen matching up to 3% of employee contributions. So if the employee contributes just 3%, the company will give the employee 3%. If you are not contributing to your 401k, please at least consider contributing up to the point where you company matches. Its free money! The main advantage to a 401k is clearly the employer matching.

What do I do?
Right now my income is low and I think it will get higher (hopefully soon!) so I have Roth IRA but I also invest in the company 401k. I have both automatically invested every month so I don’t even see it happening. Unlike a 401k, however, this feature was rather hard to set up for my Roth for some strange reason. It took me about 1 month of calling, filling out forms and waiting to get this to automatically invest. , however, I don’t have do anything. My 401k does provide a 3% match on my contributions. Right now I contribute 3% but I used to contribute (before my school expenses) about 15%. When I graduate I plan to up this amount to about 20% hopefully. The reason I choose not to do a Traditional IRA is because the basic tax deferment benefits is already occurring through the use of the 401k. My strategy is to max out the Roth IRA first through automatic monthly investment. The reason I do this is so I can benefit from tax-free gains in the future and have the freedom to determine how I want my Roth invested. If I want all cash I can do that, if I want a specific mutual fund, I can do that, and if I want to pick 10 mutual funds I can do that too. There is pretty much no limit to what I can do investing in stocks/mutual funds/bonds. I enjoy this freedom and have this fully allocated to equities to benefit from future tax-free gains. On the 401k side, my investment choices are quite limited, so I try to protect principal as much as possible. I have about 50% invested in bonds, 40% in cash and only about 10% in equities/mutual funds. My 401k and Roth IRA are about the same size but for 2008, my Roth lost about 30% while the 401k lost about only 10%. That was by design and I couldn’t be happier with the results. Well I take that back, I would be happier if they were up! Overall an appropriate investment account should be selected based on each individual’s person situation and of course I make no recommendations. I’m just sharing my thoughts!