Individual Retirement Accounts
Individual retirement accounts (IRAs) have evolved in the more than twenty years since they were established and now include such variations as SEP IRAs, Roth IRAs, SIMPLE IRAs, and more. IRAs provide the same tax-deferred benefits as 401(k) and similar employer-sponsored plans and allow you to decide how your funds will be invested.
If you have employment income in any year, you can make contributions to an IRA. The annual limit was $5,000 in 2008, and you're allowed to make an additional contribution once you reach age fifty. You can set up an IRA through most banks and financial institutions, or through a mutual fund company or broker. You can start making withdrawals at age fifty-nine and a half, and you must start doing so by age seventy and a half. As with 401(k) plans, income tax and a 10 percent penalty apply to any funds you take out early unless you qualify for a waiver of the penalty (for very high medical expenses, disability, death, or higher education, among other uses).
Contributing to an IRA doesn't make sense unless you're maximizing the match that you can receive from your employer in your 401(k) plan. After that, you can decide where you prefer to contribute additional dollars each month. Take into account the costs, investment selection, and control over the money as you make this decision. If you don't have access to an employer-sponsored plan, then by all means, invest as much as possible in IRAs.
Take advantage of every opportunity to plan for retirement. You'll want to know as soon as possible whether or not you're on track to retire in comfort. If you're not, it's easier to make changes while you're young.
Try searching the Web for “retirement calculator,” or use one provided by your employer-sponsored plan.
Keep in mind that IRAs can be held anywhere. Many people are under the impression that IRAs exist only at your bank or credit union. However, mutual fund companies, brokerage houses, and financial advisors also offer IRAs. The IRAs in banks and credit unions typically allow you to invest only in CDs or cash equivalents, which may not be the best choice for a young person's retirement savings.
Traditional IRAs
Depending on your income and whether you have a qualified retirement plan at work, your IRA contributions may not be fully tax-deductible. If you (and your spouse) aren't eligible for any employer-provided retirement plan, you can generally deduct the full contribution to an IRA. If you (and your spouse) do participate in an employer's retirement plan (see if the pension box on your W-2 is checked), you'll be able to take the full deduction if your adjusted gross income (AGI) is below $75,000 (for 2007; this limit increases periodically to keep up with inflation). If your AGI is between $50,000 and $60,000 (for singles), and between $75,000 and $85,000 (for married couples), you'll only be able to take a partial deduction. You have until April 15 to make an IRA contribution for the previous year, but make sure you do it before filing your income taxes. The IRS will check to make sure your contribution was made within the deadline.
Roth IRAs
There are several important distinctions between traditional IRAs and Roth IRAs. Traditional IRA contributions are tax-deductible as long as you qualify with the eligibility restrictions discussed above. Roth IRA contributions are not. Traditional IRAs grow tax-deferred until you withdraw the funds at retirement, and then they're taxed at your regular income tax rate. Roth IRA earnings are never taxed, as long as you follow all the rules. You're required to withdraw a minimum amount each year from your traditional IRAs once you reach the age of seventy and a half. There are no such requirements for Roth IRAs.
The income limits for Roth IRAs are much more liberal and you can contribute even if you participate in an employer-provided retirement plan. To make the full contribution in 2007, your income must be $156,000 or less if you're married filing jointly and $99,000 or less if you're single. You can make a partial contribution if your income is between $99,000 and $114,000 if you're single and between $156,000 and $166,000 if you're married. If your income exceeds these limits, you can't contribute at all.
If you're not eligible to contribute to a Roth IRA due to high income limits, you may still be able to save Roth-type money. Roth 401(k) plans allow you to save after-tax money regardless of your income. The challenge is finding an employer who offers such a plan.
Choosing the Best IRA for You
It can be difficult to determine whether you'd come out ahead in the long run with a traditional or a Roth IRA. It depends on a number of factors, such as how long before you retire, when you plan to start taking money out, and your tax bracket now and at retirement. There are benefits to Roth IRAs besides tax-free earnings. In some cases you can withdraw your contributions before retirement without owing taxes or penalties, although you may have to pay taxes on the earnings. You can withdraw up to $10,000 in earnings without penalty to buy your first home if the money has been in the Roth IRA for at least five tax years, to pay medical expenses exceeding 7.5 percent of your gross income, to pay college expenses for certain family members, or if you're unable to work because of disability. Any other withdrawals before the age of fifty-nine and a half will be subject to the penalty.
If your income exceeds the limits for a traditional IRA, you can still contribute but it won't be tax-deductible. Since tax-deductibility is the biggest advantage of a traditional IRA, if you don't qualify for the tax deduction, then a Roth IRA is probably the best choice.
Diversify
Just as you diversify your investments, you should diversify your tax strategies. It's a good idea to have some money in each type of account. Since you never know what's going to happen with tax laws in the future, you should avoid having all of your eggs in one “tax basket.”
As you decide how much to save in each type of account, consider your income, your prospects for the future, and your thoughts on future legislation. If you are relatively young and just starting your career, chances are that you are not earning much money (and therefore paying taxes at a relatively low rate). In that case, getting a deduction may not be worth much to you — and you might prefer the potential to take your money out tax-free in retirement. In addition, the ability to take back your contributions at any time may serve as a safety valve. You don't need to worry about taxes and penalties if you need to get that money back.
On the other hand, tax deductions are very valuable for some people. As you move up the income scale, a deductible contribution to your IRA or 401(k) can save you a bundle. In addition, some people prefer to get something of value today instead of hoping for something of value later. They'd rather take a deduction because they are certain they can get it. They are not as certain about future tax law changes. In a worst-case scenario, Congress could decide that Roth was a bad idea — and charge everybody income tax on distributions anyway!
