Introduction to 401ks and Roth IRAs-A Guest Post

On Monday No Credit Needed posted about how to get out of debt. Today we are lucky enough to have Jim from Bargineering, another very popular and well respected personal finance blogger*, providing our guest post. NCN and Jim’s articles are, by design, tied together. NCN taught us about how to get out of debt, and Jim is discussing investing-specifically what to do once you are OUT of debt.

*note: Jim’s blog has almost 5,000 subscribers, he’s been written about in the New York Times , and he is the creator of the Festival of Frugality. This guy knows what he is talking about!

I really believe in investing-even if I really only understand the basics. For me frugality is about being able to live the good life on what you earn. Getting out of debt, and saving on your current expenses are the immediate concerns, and the ones I tend to focus on. Yet equally important is thinking about the future and planning so that you can continue to live that “good life”-even after you retire. To that end Yankee Bill and I believe in actually living a more modest lifestyle than we can afford now in order to have money to put away for the future.

So now that you’re out of debt, it’s about time to start thinking about saving for the future. For a future where you can stop going to work every day but still be able to sustain the life you’ve grown accustomed to, or at least close to the life you’re grown accustomed to. I mean retirement of course! It’s always difficult to balance debt payments and retirement savings because it’s like picking between two holes to fill, but now that you’re out of debt, or close, you should start thinking about how you will save for the future. The two main vehicles for retirement savings are the 401k (or any employer sponsored deferred-tax retirement vehicle) and the Roth IRA. The two are very different, serve two different purposes, and understanding both will be the key to a comfortable retirement.

The 401 is a tax deferred retirement plan which means that you don’t pay taxes on your contributions. When you opt to contribute to a 401k, the funds are tax deductions and you are not taxed on those earned dollars. Those funds are taxed only when you start taking payments in retirement, so they are permitted to grow tax free. This allows you to start with a bigger pot of money in your retirement fund since it wasn’t taxed and is best for those who believe their tax rate in retirement will be lower than their current rate. Even if it’s not, the power of the larger pot is still valuable. Finally, many employers offer a percentage contribution match to employee contributions. The contribution limits to the 401k is $15,500 for those under 50 and $20,500 for those over 50.

Now, what about this Roth IRA? A Roth IRA’s contributions are not tax deductible, you contribute post-tax funds to the account but they also grow tax free. The benefit of this account is on the payments end, you don’t have to pay for taxes when you start taking payments. The 2007 contribution limit for the Roth IRA is $4,000 for those under 50 and $5,000 for those over 50. There are income-related contributions restrictions for the Roth IRA and the phaseouts start at $99,000 and end at $114,000, so if your modified adjusted gross income falls in that range then you’ll be limited based on a linear scale. I made a full writeup of all the comprehensive guide to IRS income phaseout rules that explains many of the income phaseouts, including the Roth IRA.

I hope that brief introduction to 401k’s and Roth IRA’s hasn’t scared you off! Retirement planning is very important and the earlier you start the better, I hope my brief introduction has helped you understand, at least superficially, the two most important retirement vehicles out there and that you start accounts in both today!

Jim has been blogging about personal finance for nearly three years over at Blueprint for Financial Prosperity and at My Retirement Blog, where you can find more brilliantly insightful articles such as this one.