Retirement: IRAs

An IRA is an Individual Retirement Account that allows you to save up to $4,000 ($5,000 if you turn 50 by year's end) per year in a tax- deferred account. Married couples with one income can put $4,000 ($5,000 if you both turn 50 by year's end) more in a spousal IRA. The main benefit of an IRA is that you get a tax deduction for your contributions, so the tax on this money is deferred until you withdraw it from your IRA account. Since your income will probably be lower when you retire, you likely will pay a lower overall tax on this money.

To put this in practical terms, if you save $1,000 in an IRA, and you are in the 32% tax bracket, you will save $320 on your current taxes. The tax on that income is deferred until you take the money out of the account. But since you will be retired then, your tax bracket may have decreased to 25%. So when, at age 65, you take the money out of the IRA account, you will only pay $250 in tax. While $70 of savings doesn't seem like much, you are likely to have saved much more than $1,000 by the time you retire. If you save $100,000, your savings will be $7,000!

Another potential advantage of an IRA is that you have the freedom to choose which investments you would like to make with your money. One restriction with an IRA is that you must begin taking withdrawals from your IRA by age 70 and a half.

Roth IRA
If your household income is less than $160,000, or $110,000 if you are single, you may want to contribute to a Roth IRA instead of a traditional IRA. While contributions to a traditional IRA are tax deferred, you get no current tax deductions for money put into a Roth IRA. But your money grows tax-free in a Roth IRA, so when you take out funds from the IRA, you are not taxed on that money or the interest it has earned.

Another difference between a traditional IRA and a Roth IRA is that a Roth IRA does not require you to withdraw funds from your IRA at age 70 and a half. If you are employed, you can even continue to contribute money into that account.

401(k) Plan
If your employer offers a 401(k) plan, you are being offered a great tool to start saving for retirement.

A 401(k) plan allows you to take money out of your paycheck before taxes and put it into an investment account. You are not taxed on this money until you take it out of the 401(k) account, hopefully when you retire and are in a lower tax bracket.

Your employer may also provide matching funds, up to a certain percent of your income. So, for example, if your company offers 50 cents on the dollar up to 3% of your income, that means if you put $50 a month into your 401(k) account, your employer will add an additional $25 into your account. But if you earn $2000 a month, the maximum your employer will contribute is $30 a month.

The money your employer contributes to your 401(k) account is not automatically yours. You have to be "vested." To be vested, you have to stay with the company for a certain length of time according to the schedule your employer determines. After that time, any money your employer contributes to your 401(k) money IS yours.

One more important fact about 401(k) funds - if you decide to withdraw your money BEFORE you retire, you will pay a 10% penalty to the IRS AND be taxed on that money. So only withdraw money from a 401(k) as a last resort! Your employer may allow you to borrow money from your account, without penalty. You will, however, pay interest on the loan. But the interest goes right back into your account so you don't actually lose any money in borrowing. Borrowing will slow down your investment growth.