We hear a lot about retirement accounts, but I wanted to spend today’s post explaining the different types of accounts.
Traditional IRA – Individual Retirement Account
Individuals can set up these accounts and invest for their retirement. Individuals put away pre-tax income in these accounts so that when they retire, they’ll have income saved up.
Advantages
The big advantage of putting money away in an IRA is that all money deposited into the IRA is tax deductible, so instead of paying taxes and then investing, as you do with regular investments, the money goes straight into the account without being taxed first.
Distributions
That doesn’t mean that tax is never paid on that money. When it is time to take distributions in retirement, all the investments and all interest earned is taxed as ordinary income at your normal tax rate.
Limits
For 2009 and 2010, the contribution limit on IRAs is $5,000 each year, although depending on your filing status and job status, the limits are phased out beginning at an income of $55,000 for individuals and $89,000 for couples. In addition, those who are 50 or older can make an additional catch-up contribution of $1,000.
401(k)
These accounts are similar to IRAs in that contributions are pre-tax. These plans are usually employer sponsored plans where employees have a portion of his or her wages paid directly to the 401(k) account.
Advantages
401(k)s have similar tax advantages to IRA in that all contributions are pre-tax. Additionally, some employers choose to “match” part or all of the employee’s contribution. (This ranges, but employers often give a 50% match on employee contributions, of up to 6% of his or her salary.)
Distributions
Distributions work in similar ways to IRAs, and all distributions of contributions and interest income are taxed. There are heavy penalties for withdrawing funds before the permitted age of 59 1/2.
Limits
Another advantage of 401(k) accounts is that the contribution limits for 2009 and 2010 are $16,500, over 3 times that of traditional IRAs. In addition, employees who are 50 years old or over are allowed to make additional pre-tax catch-up contributions of up to $5,500 in 2009.
Roth IRA
This retirement savings plan consists of after-tax contributions.
Advantages
Contributions are made after taxes, so all earnings made over the life of the IRA are tax free upon disbursement. In addition, contributions may be withdrawn at any time without any penalties, something that can’t be done with traditional IRAs.
Distributions
Direct contributions can be withdrawn at any time. However, there are restrictions on when earnings can be withdrawn without tax or penalty. First, 5 years must have elapsed since the opening of the Roth IRA. In addition, the individual must be 59 1/2 years old.
Limits
The contribution limits are similar to that for traditional IRAs, $5,000 for 2009 and 2010. Single filers earning up to $105,000 qualify for a full contribution, while joint filers earning up to $166,000 qualify for a full contribution. After that, the contribution limits are phased out.
Roth 401(k)
This employee-sponsored option combines the features of the Roth IRA and tradition 401(k) plans. This is typically the best options for those who are eligible.
Advantages
Contributions are made after-tax, and all contributions and earnings can be withdrawn at any time tax and penalty-free. These plans are best for younger workers who are currently taxed in a lower tax bracket but expect ot be taxe din a higher bracket upon reaching retirement age.
Distributions
Required distributions begin at age 70. All contributions and earnings can be withdrawn at any time tax and penalty-free after they meet the two restrictions: they must be open for 5 years and the individual must be 59 1/2.
Limits
Contribution limits are the same as for traditional 401(k) plans.
Next week, I’ll go over which plans are best for individuals in different situations. Plus, we’ll talk about options for those who have 401(k) accounts when they leave their employers. Send in your questions, I’ll try my best to answer yours!
