Individual Retirement Savings Options
Individual Retirement Account (IRA)
An IRA is a personal savings plan that allows you set aside a certain amount of money each year for retirement while reaping government-allowed tax breaks. There are two main types of IRAs most people use (self-employed individuals have a few other options):
Traditional IRAs, which lower your taxable income (and therefore, your income tax amount) during the year in which you contribute. Your contributions and their investment earnings grow tax-free until you withdraw them – usually at retirement. However, your withdrawals will be taxed at your income tax rate at the time of withdrawal, which for most retired people is lower than when they were employed. You must begin taking distributions from a traditional IRA beginning in the year in which you turn 70 ½.
Roth IRAs, which offer no immediate tax deduction during the year in which you contribute – in other words, you contribution money that has already been taxed. However, you will be able to withdraw the money you've accumulated, tax-free. Certain higher-income individuals are limited in how much they can contribute to a Roth, but there is no mandatory withdrawal age. Roth IRAs are also more flexible if you need to withdraw some of the money early.
The maximum annual contribution to either type of IRA is $5,500 in 2013, plus an additional $1,000 if you are 50 or older.
401(k) and Other Workplace Retirement Savings Plans
Many employers offer a 401(k), 403(b) or 457 plan to their employees as a way to save money toward their own retirement. Typically, you make contributions toward these plans on a pretax basis; that is, the money is withdrawn from your pay before federal and state income taxes have been deducted. This lowers your taxable income, and thus, your taxes.
Then, your contributions and their interest earnings grow tax-free, until you withdraw them, usually at retirement when your taxable income, and therefore your tax rate, may be lower than during your employment years.
In addition, many employers have begun offering Roth 401(k) plans, which combine the features of a regular 401(k) with those of a Roth IRA. With a Roth 401(k) you contribute after-tax dollars. Although you don't get an upfront tax break, your account grows tax-free and withdrawals aren't later taxed, provided you've had the account at least five years and are age 59 ½ or older – or have become disabled or die.
Many employers also match a portion of the contributions employees make to their 401(k) account. These matching contribution amounts vary widely from employer to employer (usually from 25 percent to 100 percent of your contributions, up to a set percentage of your pay). In addition, some employers will increase their match based on your years of service.
You are always 100 percent vested in (that is, have complete ownership of) your own contributions. Some employers make you fully vested in their matching contributions immediately, while others have a vesting schedule outlining how much of the company-matching contributions and their investment earnings you own at any given time. In the latter case, if you left the company before being fully vested, you would lose a portion of the company-matching contributions (but not of your own contributions). Check your plan documents to see if this applies.
One more important fact about 401(k) plans: If you decide to withdraw your money before reaching age 59 ½, you will likely pay a 10 percent penalty to the IRS as well as pay regular income tax on that money. So only withdraw money from a 401(k) as a last resort.
Simplified Employee Pension (SEP) IRA
Self-employed individuals have a number of options to choose from as well. Probably the most widely used is the Simplified Employee Pension (SEP) IRA. In these plans, you contribute directly to an IRA on your behalf. The annual minimum wage for participation in 2013 is $550 and the maximum contribution allowed is a percentage of pay (25 percent for companies; 20 percent if self-employed) up to an annual pay limit of $255,000.
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