Start early!
Mar 12 '00
Retirement planning is important. No doubt, you've heard that hundreds of times, yet a lot of people seem to ignore that. This is especially true for younger people who think they're too young to worry about retirement. Sure, Social Security is there, but will it be there when you're ready to retire? And if so, it will almost never provide you with an adequate income that only additional retirement savings will be able to provide you with. Well, the fact is: the earlier you start, the more you'll thank yourself later. Besides, retirement planning isn't just for retirement anymore. Think of it as an investment with tax benefits.
When talking about different retirement plans, you need to understand several terms:
Tax-deductible - You can deduct this amount from your gross income to pay less taxes in a current year.
Tax-deferred - Your otherwise taxable income on the account is deferred until you withdraw money form the account.
Tax-free - You're not required to pay taxes on these amounts.
Several general rules apply to all retirement plans:
- If you're eligible, there is no minimum investment.
- Margin trades, commodities trades, naked options trades are not allowed.
Now, there are several options out there for your retirement planning. Not all of them are available to everyone, and certainly not all are suitable for everyone. I'll try to concentrate on three major ones and I'm hoping to help you understand them and make the best choice.
Traditional IRA. This is the original Individual Retirement Account.
How it works: Your annual investment is tax-deferred. Depending on your income and contributions to other retirement plans, it might also be tax-deductible. Usually one-time contribution is made between January 1 of the tax year for which the contribution is made and April 15 of the following year.
The limits are as follows: Annual contribution limit is $2,000 and has been that for some time now. It's $4,000 for married couples filing joint tax returns. You can make contributions if you do not participate in your employer's retirement plan AND if you are single and your income does not exceed $31,000; partial contributions for $31,000 to $41,000; and phasing out at over $41,000. For married couples filing jointly respective numbers are full below $51,000; partial if $51,000 to $61,000; and phasing out above $61,000.
Withdrawal rules: Distributions are allowed without penalty if the it is made on or after the date you reach age 59 1/2, and it's taxed at your current tax rate as if it was your income in that tax year. If you withdraw early, then the distribution is subject to an additional 10% penalty tax.
What else you should know:
- Contributions to an IRA may not be made after you reach age 70 1/2.
- Also, if you do not start withdrawing money from your IRA by the age 70 1/2, you will be subject to penalties.
Think of it as: A small brokerage account with all tax payments and withdrawals suspended until you're 59 1/2. If you happen to qualify, your investment is deductible, too.
Roth IRA. This is a new type of IRA created by the Taxpayer Relief Act of 1997.
How it works: Your annual investment is not tax-deductible. However, if certain conditions are met, distributions are tax-free. Much like the traditional IRA, one-time contribution is usually made between January 1 of the tax year for which the contribution is made and April 15 of the following year.
The limits are as follows: Annual contribution limit is $2,000; $4,000 for married couples filing joint tax returns. You can make contributions if you are single and your income does not exceed $95,000; partial contributions for $95,000 to $110,000; and phasing out at over $110,000. For married couples filing jointly respective numbers are full below $150,000; partial if $150,000 to $160,000; and phasing out above $160,000. Unlike standard IRAs, your active participation in another retirement plan does not affect your eligibility to contribute to a Roth IRA.
Withdrawal rules: Distributions are not taxable if the account has been in place for at least five years and the distribution is made either:
- on or after the date you reach age 59 1/2;
- in the event of your death or permanent disability; or
- for a "first time" home purchase and does not exceed $10,000 (a lifetime limit).
The "first time" home purchase exception applies even if you previously owned a
home, as long as neither you nor your spouse had an ownership interest in a principal
residence in the prior two years. If a distribution does not meet these requirements, then it may be taxable.
What else you should know:
- Unlike Standard IRAs, contributions to a Roth IRA may be made after you reach age 70 1/2.
- The taxable portion of a distribution from a Roth IRA is also subject to a 10% penalty tax, except several emergency situations, such as permanent disability.
Think of it as: A small brokerage account with withdrawals suspended until you're 59 1/2, with ABSOLUTELY NO TAXES OWED.
401(k). This is an employer's retirement plan.
How it works: Your annual investment is tax-deductible. It is usually deducted regularly directly from your paycheck during the calendar tax year for which the contributions are made. Unlike the IRAs, the contribution choices are limited by your employer to several mutual funds and employer's stock.
The limits are as follows: Unlike the IRAs, the annual contribution limit is much higher and changes often to keep pace with inflation; this year it's set to $10,500.
Withdrawal rules: Distributions are not penalized if it is made on or after the date you reach age 59 1/2, or in case of an "extreme hardship," which you have to prove. Otherwise, you pay the same additional 10% penalty tax, as in case of the IRA.
What else you should know:
- Most employers set an additional limit of your contribution as a percentage of your salary, usually up to 15%.
- Many employers match your some or all of your contributions to 401(k) dollar for dollar. They usually set a minimum time limit for employees to stay at their position to keep the matching contributions. Check with your employer.
- Employers often allow employees to take loans against their 401(k) plans. Unlike withdrawals, if you're making repayments, loans are not taxed or penalized. Check with your employer for details, but usually these are offered at very unfavorable conditions.
Think of it as: A brokerage account with tax-deductible and tax-deferred investments, but limited investment choices.
BOTTOM LINE
A lot depends on your particular financial situation and you should perhaps consult a tax adviser or a financial planner. Many limits change as often as every year, so make sure you know them from the IRS, your employer, your accountant, etc. However, in a majority of cases these are your best options:
1. If your employer offers 401(k) plan, use it! Contribute as much as you can, especially if your contributions are matched.
2. If you don't have 401(k), and you qualify for a tax-deductible IRAs, contribute your full $2,000. This is the best investment you can make: tax-deductible AND tax-deferred.
3. If you do not qualify for tax-deductible IRAs, consider Roth IRAs. There is no reason not to invest, since your contribution is tax-free. If you think that at the time of your retirement, your tax rate will be higher than today's, Roth IRA is a better investment than the Standard IRA. Also, consider Roth IRA even if you already contribute to 401(k). There are no limitations.
Finally, here is a list of a few lesser-known retirement options that might be available to you:
1. 403(b) - Similar to 401(k) plan, administered by non-profit, tax-exempt employers to their employees.
2. Keogh - Retirement plan for self-employed.
3. SIMPLE - Plan similar to 401(k) for small-business employees (of companies with less than 100 employees), with required matching contributions.
4. Education IRA - Similar to Roth IRA, designed to help save money for children's future education (see my upcoming review).
Happy retirement planning. And remember: your IRA and Roth IRA contributions for 1999 tax year can still be made until April 17, 2000!
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