Roth IRA question

[Coronet]

I have a question about Roth IRAs. I'm 23, just started a job, and it was suggested to me to open a Roth IRA. I currently have both a 401k and Roth 401k and make contributions to them monthly. I'm trying to understand a few things about the Roth IRA:

From what I read Roth IRAs grow tax free. So every dollar I invest won't be income taxed while it's growing and won't be taxed when I eventually start to take the money out when I'm 59.5+. Is this correct?

I'm a bit confused how this is so beneficial in one way: they are saying it grows tax free, but your initial investment (say I put $5k in for 2011) would have been taxed as income from my job anyway, right? So, from my understanding, this seems to be exactly like my Roth 401k account.

As someone who does not cap my contributions to my Roth 401k each year, would it be beneficial to open a Roth IRA? I get the feeling the point of a Roth IRA is for those of you who max out your Roth 401k each year and want the surplus savings they have to go into another retirement account.

Am I thinking about this incorrectly or should I still consider a Roth IRA?

[bjl584]

You are correct. The money that you put in has already been taxed, so no taxes on any earnings that you get while in the Roth and no taxes when you draw the money out.

[skydivingchic]

You are correct that the tax treatment of a Roth IRA and a Roth 401k are the same. The possible advantage of a Roth IRA over a Roth 401k is investment choice and control. Generally your options within a 401k are limited as to what funds you can buy. Some companies only offer funds with high loads or fees within their 401k programs. Or maybe you are looking for a sector fund instead of more general mutual funds - not all 401k plans have those options. So in that case a Roth IRA is more advantageous because you can buy anything you want within the IRA instead of being limited to fund choices you aren't happy with. Not all companies offer Roth 401k options, so you are lucky in that sense.

[CalisFinancialGuru]

At your age the ROTH IRA is a great option. Since it is being funded with after-tax money (your job income) it will not be taxed when withdrawn in retirement. With a Traditional IRA it is the opposite (deductible on taxes but will be taxed when withdrawn in retirement). I would assume your goal is to raise your income gradually over your lifetime (should be everyones goal!), therefore you will most likely be in a higher tax bracket in retirement then the one you are in now. The ROTH IRA would allow you to put away money for retirement at your current low tax rate (this is also assuming you are not already in a high tax bracket). I would suggest sticking with the ROTH IRA for now since this advantage is possibly highly in your favor. Hope this helps!

[Mithrin]

The advice that I follow for retirement funding is:
1. First contribute enough to plan through work (401K, etc.) to take advantage of any available company matching.
2. Next, contribute to a Roth IRA.
3. Go back to the work plan and contribute up to the annual limit.

Besides the investment options, another potential benefit of the Roth IRA is the ability to withdraw contributions without incurring tax penalties, at any time for any reason.

I don't know if your Roth401K makes it easy to withdraw contributions or not, but for a Roth IRA, since your contributions have already been taxed, you can take them out if you have to without penalty. The downside is that you can only contribute 5K/year, and if you make withdrawals, you can't put that money back later.

You also have to make sure you only withdraw up to your contributions, and leave any profit in the IRA--if you put in 5K/year for 5 years, you can withdraw up to 25K (your total contributions) without penalty; if you withdraw 30K, then the 5K of earnings you are withdrawing becomes subject to penalties.

So, if you're like me and are not able to max out both the 401K and IRA limits every year, first take full advantage of any company matching (if any), then put money towards the 5K/year IRA limit, and if able, put additional money towards your company plan until you're maxxing that out too.

[disneysteve]

Do Roth 401k accounts have the same minimum withdrawal requirements as regular 401k accounts? If so, that would be another advantage of a Roth IRA. You are better able to control how you draw down that money in retirement.

[skydivingchic]

Good point, DisneySteve and one I hadn't considered. A quick google search confirms that a Roth 401k are subject to Required Minimum Distributions like a regular 401k. So tax wise there is no real difference between the two, but there are other considerations which may or may not be important to you.

[disneysteve]

I'd say if there is no company match, or you've already put in enough to get the full match, your next $5,000 should go into a Roth IRA, not a Roth 401k. All things considered, the greater degree of control of how you invest that money, lower expenses most likely and complete control over how you withdraw the money make the Roth IRA the better deal.