Saving up money for retirement is one of the largest and most important financial commitments that you can make in life. For a comfortable retirement, you may need to amass hundreds of thousands, if not, millions of dollars before leaving the workforce. As part of the retirement planning process, it is critical that you make use of retirement accounts. To begin, you must distinguish between 401(k), Traditional IRA, and Roth IRA plans.
Tax-Deferral and Retirement Account Types
All retirement accounts feature tax deferral. Tax deferral means that you will not owe taxes on interest income, dividend payments, or capital gains as they occur within your retirement accounts. Popular retirement accounts include 401(k), Traditional IRA, and Roth IRA plans. 401(k) and Traditional IRA contributions are made with pre-tax money. Because of these tax deductible contributions, your 401(k) and Traditional IRA withdrawals will be taxed as ordinary income. Alternatively, you would direct after-tax cash into a Roth IRA account, which does translate into tax-free withdrawals upon retirement.
Contributions and Compound Returns
The IRS enforces contribution limits for all retirement accounts. As of 2010, you are generally limited to $5,000 worth of total annual contributions into a Traditional and Roth IRA, combined. For the 401(k) plan, the IRS generally imposes a $16,500 yearly contribution limit. Knowledge of, and an attempt to meet these contribution limits does allow you to take advantage of investment compounding for large gains. For example, you may opt to sock away $400 each month into a Roth IRA and $1,100 each month into your 401(k) — for $1,500 in total monthly retirement contributions. A $1,500 monthly investment that earns a 10 percent return grows to $1.2 million — in 20 years.
Early Withdrawal Penalty
Be advised that retirement plans typically expose you to the 10 percent additional tax penalty — if you take withdrawals before age 59 ½. You may be able to bypass the penalty tax — if your withdrawals are being spent upon a first-time home purchase, medical bills above 7.5 percent of your taxable income, or for college tuition costs. The IRS also waives the 10 percent additional tax penalty in case of disability. The IRS defines disability as a permanent condition that makes it impossible for you to work any job.
Strategy
Because of the employer match, your 401(k) should be the focal point of your retirement plan. As part of your employee benefits’ package, your employer will match your 401(k) contributions on a dollar-for-dollar basis up until a certain point. Your 401(k) contributions should maximize the benefits of this free money. From there, you can put money into a Traditional or Roth IRA according to your income level. As a young professional, a Roth IRA would be more so ideal, because you expect to retire in a higher tax bracket and would then benefit most from tax-free withdrawals. As a high earner at present, you would favor a Traditional IRA to take immediate advantage of its tax breaks.
The Benefits of Retirement Accounts, Sources:
IRS: Publication 590 – IRAs
IRS: Roth IRAs
IRS: 401(k) Plans
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