How to Prioritize Multiple Retirement Accounts

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This article is by staff writer Kevin Mulligan. Kevin is developing a freelance writing career focused on personal finance.

In the past you would rely on your company pension and social security to provide for your retirement. You worked for a long time, retired, and lived off of those two sources of income.

Today pensions have all but disappeared and the thought of relying on social security alone should make you nervous.

No, today you have to take charge in your retirement. And the financial industry (and Congress) have moved to meet the task with a multitude of options for you. Of course there are so many options, offerings, and fine print that those options can be overwhelming.

Let’s compare three popular retirement account options from the 30,000 foot view. In the future we’ll dig into some of the nitty gritty details.

The 401(k) Plan

Of the three accounts we are reviewing the 401k is likely to be the most well known due to the large number of firms that offer the plan to their employees.

The 401k also offers you the opportunity to set aside the most money of these three accounts — $16,500 for 2010, plus an additional $5,500 if you are over age 50! That’s $22,000 you can set aside for retirement every year if you’re over 50.

Not to mention that many employers are restoring company matches to your 401k contributions coming out of the recession. That’s even more cash that you can put back for your golden years.

There are a lot of positives. However, there are some downsides.

You cannot control your investment options. It’s your account, but the company owns the plan and chooses the investment options. You also may be incurring hidden investment fees that are hidden deep within fine print — and there’s not much you can do about it unless you choose not to participate in the plan.

In the “could be good, could be bad, it really depends on your situation” category is the tax deduction you receive by investing in your 401k plan. Your contributions are a pre-tax deduction on your earnings which saves on taxes in the year you contribute to the 401k.

The Traditional IRA

The traditional IRA is similar to the 401k in that it is a pre-tax deduction, and it’s a retirement account.

That’s pretty much where the similarities end.

The IRA part of Traditional IRA stands for Individual Retirement Account (or Individual Retirement Agreement). The account is yours as an individual. Your company doesn’t own the account, and your company won’t offer you a match on your investments in your IRA.

Since you own the account you get to choose where it is held — your local bank, a major brokerage firm like Charles Schwab, or your favorite mutual fund company like Vanguard. You also, theoretically, should be able to see how much the plan is charging you because you choose the firm and the investments.

Where you can invest $16,500 in your 401k you can only invest $5,000 in a Traditional IRA in 2010. If you’re over age 50 you can also invest an additional $1,000 in “catch up” contributions.

There are income limitations that can restrict how much you can invest in a traditional IRA and receive a tax deduction. (You can still invest, but you may not receive the deduction.) We’ll discuss income limits in a future article, but know that this is an additional complication to investing in these types of accounts.

The Roth IRA

Roth IRAs are the new kids on the block. They are similar to Traditional IRAs in that you own the account, not your company. You choose the investments, and you should be able to see the costs that are involved. You won’t receive a match on any money you contribute, and there are income limitations to consider.

However, the major difference between the other two accounts and the Roth IRA is that your Roth IRA does not provide a tax deduction. You are investing after-tax funds. Where Traditional IRA or 401k funds will be taxed when they are withdrawn in retirement, Roth IRA investments have already paid income tax and will not be taxed.

Depending on your circumstances this can be seen as either a benefit or a downside to using these accounts. If you anticipate your income tax rate being higher in the future then paying taxes today lets you avoid paying higher taxes in retirement. If you anticipate your income tax rate dropping in retirement then paying tax today wouldn’t be as attractive as waiting until retirement.

At Least You’re Saving for Retirement

We’ll look into the finer details of retirement accounts in the future.

Regardless of your thoughts on…

• potential income tax rate increases
• taking deductions now or paying tax now
• your employer’s investment options

…one thing remains true: investing for retirement in any of these three accounts is a step in the right direction.