What Is a Traditional IRA?
Traditional individual retirement accounts (IRAs) can be a good way to save for retirement. If you do not participate in an employer-sponsored retirement plan or would like to supplement that plan, then a traditional IRA could work for you.
A traditional IRA is simply a tax-deferred savings account that is set up through an investment institution and has several investing options. For instance, an IRA can include stocks, bonds, mutual funds, annuities, cash equivalents, real estate, and other investment vehicles. One of the benefits of a traditional IRA is the potential for tax-deductible contributions.
In 2010, you may be eligible to make a tax-deductible contribution of up to $5,000 ($6,000 if you are 50 or older). Contribution limits are indexed annually for inflation.
You can contribute directly to a traditional IRA or you can transfer assets directly from another type of qualified plan, such as a SEP or a SIMPLE IRA. Rollovers may also be made from a qualified employer-sponsored plan, such as a 401(k) or 403(b), after you change jobs or retire.
Not everyone contributing to a traditional IRA is eligible for a tax deduction. If you are an active participant in a qualified workplace retirement plan — such as a 401(k) or a simplified employee pension plan — your IRA deduction may be reduced or eliminated, based on your income.
Non-deductible contributions may necessitate some very complicated paperwork when you begin withdrawals from your account. If your contributions are not tax deductible, you may be better served by another retirement plan, such as a Roth IRA.
The funds in a traditional IRA accumulate tax deferred, which means you do not have to pay taxes until you start receiving distributions in retirement, a time when you might be in a lower tax bracket. Withdrawals are taxed as ordinary income. If taken prior to age 59½, withdrawals may also be subject to a 10% federal income tax penalty. Exceptions to this early-withdrawal penalty include distributions resulting from disability, unemployment, and qualified first home expenses (up to a $10,000 lifetime cap), as well as distributions used to pay higher-education expenses.
You must begin taking annual required minimum distributions (RMDs) from a traditional IRA after you turn 70½ (starting no later than April 1 of the year after the year you reach 70½), or you will be subject to a 50% income tax penalty on the amount that should have been withdrawn. Of course, you can always withdraw more than the required minimum amount, or even withdraw the entire balance as a lump sum.
What Is a Roth IRA?
Roth IRAs are tax-favored financial vehicles that enable investors to save money for retirement. They differ from traditional IRAs in that taxpayers cannot deduct contributions made to a Roth. However, qualified Roth IRA distributions in retirement are free of federal income tax and aren’t included in a taxpayer’s gross income. That can be advantageous, especially if the account owner is in a higher tax bracket in retirement or taxes are higher in the future.
A Roth IRA is subject to the same contribution limits as a traditional IRA ($5,000 in 2010). Special “catch-up” contributions enable those nearing retirement (age 50 and older) to save at an accelerated rate by contributing $1,000 more than the regular annual limits.
Another way in which Roth IRAs can be advantageous is that investors can contribute to a Roth after age 70½ as long as they have earned income, and they don’t have to begin taking mandatory distributions due to age, as they do with traditional IRAs.
Roth IRA withdrawals of contributions (not earnings) can be made at any time and for any reason; they are tax-free and not subject to the 10% federal income tax penalty for early withdrawals. After a minimum five-year holding period but before age 59½, tax-free and penalty-free withdrawals of earnings can be made due to a qualifying event, such as death or disability or to purchase a first home (up to a $10,000 lifetime cap).
Although college expenses are not a qualifying event, Roth IRA account owners can withdraw earnings penalty-free for qualifying higher-education expenses (for the account owner, a spouse, a child, or a grandchild). However, these withdrawals would be subject to ordinary income tax.
To qualify for a tax-free and penalty-free withdrawal of earnings in retirement (after age 59½), a Roth IRA must have been in place for at least five tax years.
Keep in mind that even though qualified Roth IRA distributions are free of federal income tax, they may be subject to state and/or local income taxes. Eligibility to contribute to a Roth IRA phases out for taxpayers with higher incomes.
What Is a 401(k) Plan?
A 401(k) plan is self-directed, qualified retirement plan established by an employer to provide future retirement benefits for employees. Employee contributions are made on a pre-tax basis, and employer contributions are often tax deductible. [Roth 401(k) contributions are made after-tax, but qualified withdrawals in retirement are free of federal income tax.] Many employers are now enrolling new hires automatically in 401(k) plans, allowing them to opt out later if they choose not to participate. This is done in the hope that more employees will participate and will start saving for retirement at an earlier age.
If you elect to participate in a 401(k) plan, you can allocate a percentage of your salary to your plan every month. The maximum annual contribution is $16,500 in 2010. If you will be 50 or older before the end of the tax year, you can contribute an additional $5,500. Contribution limits are indexed annually for inflation. The funds in your account will accumulate tax deferred until you begin taking distributions in retirement.
Employer contributions are often subject to vesting requirements. Employers can determine their own vesting schedules, making employees partially vested over time and fully vested after a specific number of years. When an employee is fully vested, he or she is entitled to all the contributions made by the employer when separating from service.
In plans that offer loans, you may also be allowed to borrow money from your account (up to 50% of the account value or $50,000, whichever is less) with a five-year repayment period. Of course, if you leave your job, the loan may have to be repaid immediately.
The funds in a 401(k) plan are portable. When you leave your job or retire, you can move your funds or take a taxable distribution. However, if you leave a company before you are fully vested, you will be allowed to take only the funds that you contributed yourself plus any vested funds, as well as any earnings that have accumulated on those contributions.
Within certain limits, the funds in your 401(k) plan can be rolled over directly to your new employer’s retirement plan without penalty. Alternatively, you can roll your funds directly to an individual retirement account (IRA) instead.
You must begin taking required minimum distributions from 401(k) plans no later than April 1 of the year after you reach age 70½. Distributions from regular 401(k) plans are taxed as ordinary income and may be subject to a 10% federal income tax penalty if withdrawn before age 59½, except in special circumstances such as disability or death.
A 401(k) plan can be a great way to save for retirement, especially if your employer offers matching contributions. If you are eligible to participate in a 401(k) plan, you should take advantage of the opportunity, even if you have to start by contributing a small percentage of your salary. This type of plan can form the basis for a sound retirement funding strategy.
