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Cramer: Untangling the IRA, 401(k) Roth mystery

Roth IRA
Jason York | Getty Images

According to Jim Cramer, it does not matter how good an investor is at picking stocks. If the funds are kept in the wrong account, tons of money could be wasted in hidden fees and opportunity could be missed.

This logic is especially applicable to 401(k) and IRA retirement accounts, and whether it makes sense to use a Roth account.

"I think that, aside from the earned income tax credit, the Roth IRA may be the single greatest thing our government has done for low-income families since the end of the war on poverty, which at best, ended in a draw, with poverty possibly winning on points," the "Mad Money" host said.

Roth or no Roth? That is the question

When deciding between a Roth IRA or 401(k) or a traditional account it depends if it makes more sense to pay income tax now, or to wait and pay income tax after retirement. This is a complicated decision that has more to do with the specifics of a situation and whether one anticipates they will be in a higher tax bracket at retirement.

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With a Roth, contributions are made with after-tax income and the money in the Roth IRA will not be taxed again. There is also an income limit, depending on if you file joint or single. According to the Internal Revenue Service, for 2016, contributions to both traditional and Roth accounts cannot exceed $5,500 for individuals under age 50, and $6,500 for those over 50.

As long as the cash remains in the Roth account, you will not pay dividend tax. The money can then be withdrawn without a penalty after the age of 59 and a half.

Another perk to a Roth IRA is that after five years, money contributed — not your gains — can be withdrawn without the usual 10 percent penalty. This is very different from a regular IRA, where there are no taxes on contributions until money is withdrawn.

"For anyone whose marginal tax rate is 25 percent or less, which is most of America, I think you go with a Roth. Better to take the hit up front, then allow your Roth IRA to compound tax free for the rest of your life," the investor states.

The same rule applies to a 401(k); however it is important to note that the contribution limits for this type of account are much higher than for an IRA. In 2016, the IRS stated a contribution limit of $18,000. Unlike a Roth IRA, there are no income limits for a Roth 401(k).

"The less you make, the more likely it is that a Roth is for you. It's that simple," Cramer said.

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