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Over the past two decades, Congress has given us a plethora of tax-advantaged ways to save for retirement. These vehicles have contributed to the investment boom of the last decade and will allow many of us to be more comfortable in retirement.
The number of vehicles available, however, have made it more important for us to be informed about the differences between the different investment vehicles. This short primer will get you started with that understanding. Because Congress periodically makes changes in these programs, it is best to check with your financial advisor or with the IRS before you make any investments.
What makes these programs so valuable is all of them are tax-advantaged in some way. In some cases you can defer taxes until later and with some you even can avoid taxes on investment income altogether.
Here are the most widely used vehicles for retirement savings:
INDIVIDUAL RETIREMENT ACCOUNTS (IRA's)
These are retirement accounts you set up with any institution that offers them (most commonly banks, mutual fund companies, and brokerage houses). You put as much or as little as you want in as long as you meet the provider's minimum and the government maximum. You space your contributions as you wish as long as you get them in on Income Tax Day on the year following the tax your you are contributing for.
These accounts are available to anyone who works. Which of the three types of accounts is available to you depends on your own personal situation.
Traditional IRA's are available to low and moderate income people or to any employed person who does not have pension plan coverage at work. The money you pay in is deducted from your taxable income. You do not pay taxes on that money or the money it earns until you withdraw it. Withdrawals are allowed at age 59 ½, if you become disabled, and under a few other circumstances. You must begin taking out the money at age 70 ½.
Roth IRA's are offered to moderate to high moderate income people as well as to lower income people. With these accounts, you do not get a tax deduction the year you contribute, but your earnings are never taxed. You can start taking out money at age 50 ½, but you never have to and can will the money if you don't need it to live on in your later years.
Non-deductible IRA's do not allow you to deduct your contribution and defers taxes on the earnings until you withdraw money during your period of retirement or disability.
KEOGH's
These are tax-deferred programs for self-employed people. You can contribute any amount from the minimum that the provider allows to the maximum that the government allows–in most cases a percentage of your self-employment income. You can space your contributions as you wish. You can have a Keogh in addition to other plans.
Keoghs act like traditional IRA's in their tax consequences. Most of the same institutions offering IRA's also offer Keoghs. There are different types of Keogh plans appropriate for different situations. Check with an advisor before you open one.
401 (k)'s
These are retirement plans offered by many private-sector employers.
Under these plans, you agree to set aside a certain amount monthly to an investment that the employer offers–usually one of about a dozen. Contributions are made by payroll deduction. In many cases the employer matches your contribution to some extent. Some plans allow you to borrow some of the money you have saved and pay it back by payroll deduction. Most allow you to roll over your money to another tax-deferred instrument if you leave the job.
401 (k)'s have the same tax benefits of a traditional IRA–the money you put in and the money the plan earns is not taxed until you take out the money after age 59 ½.
Before you start a 401 (k), be sure you understand the plan. See which investment option is best for you. Ask how often you can change where your money is investment. Ask about the company match–in some cases companies match more if you invest in that company's stock. Find out the borrowing policy and what happens when you leave the company.
403 (b)'s
These are very much like 401 (k)'s, but they are for people employed by schools, hospitals, and other nonprofit organizations.
403 (b)'s are also based on payroll deduction, but you find your own investment from a pre-approved list and bring it to the employer. There rarely is any matching. You can change your investment instructions from time to time, but there are limits.
403 (b)'s are tax-deferred in the same way that 401 (k)'s are. In most plans, you can borrow only if you invest in an insurance annuity.
VARIABLE ANNUITIES
These are investment vehicles that most advisors recommend only if none of the other vehicles work for you or if you are maxed out on the other vehicles and still have a large amount of money to shelter.
Unlike the other vehicles, you do not have to have income from work to participate in a variable annuity. You can put in as much as you want whenever you want, subject to the policies of the provider.
Variable annuities have an insurance component to them which make them more expensive than other types of tax-deferred investments. Many of them have high fees, especially ones that are operated by insurance companies. Several mutual fund companies have lower-cost variable annuities that offer a variety of investments.
Variable annuities are complex instruments. Talk to a licensed specialist from the company whose annuity you are considering before you invest.
The vehicles listed above have contributed mightily to the fiscal fitness of countless Americans. Look into them, but make sure you thoroughly understand the plan you are considering before you commit to a plan.
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