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Question for the Money Doctors

Question submitted on Dec 27, 2011.

Question

What is the difference? Traditional Ira, Roth Ira, 401 k? I had 401 k , quit my job 5 yrs ago transferred $ to a traditional Ira(30 k) now have a newborn , will be going back to work in the next year after finishing masters and would like to open college fund for daughter now with money in IRA account.

Answer

Thanks for the question.  The basic difference among the plans is when you pay the taxes.  With a traditional IRA and a 401(k), you contribute funds pre-tax (you don't pay taxes when you put money in the plan).  However, when you take money out of these plans, you pay ordinary income tax on all withdrawals at whatever tax rate is prevailing at that time.  A Roth IRA is the opposite; you pay the tax now, then withdraw the funds tax-free at a later date (including any gains).  So, the money in your IRA has not been taxed yet.  

If you take money out of your IRA, you will pay taxes and a 10% penalty if you are under age 59 1/2.  That would probably not be a wise decision.  You could begin funding a 529 plan out of current income without liquidating your IRA.  The 529 account is similar to a Roth IRA, but it is used for education rather than retirement.  If you used the funds from a 529 account to pay for qualified education expenses, then all gains are free of tax.  There are also other options, such as types of insurance plans where the cash value is treated in a similar fashion to a 529 plan or Roth IRA; but there are no restrictions as to how you can use the money.    

Be sure to consult with a tax advisor before you take any funds out of an IRA.  If you liquidate the account and fund a 529 account, then you will probably be hit with a very large tax bill in April of the next year.   

I hope this helps.

Sincerely,


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