An IRA is a retirement account that allows you to save up to a certain amount of money in a tax-deferred account. The annual contribution limit is set by the Federal government, and in 2010 is $5000 for individuals under the age of 50 and $6000 for those who turn 50 by the end of the year. The main benefit of an IRA is that you get a tax deduction for your contributions, so the tax on this money is deferred until you withdraw it from your IRA account. Since your income will probably be lower when you retire, you likely will pay a lower overall tax on this money.
To put this in practical terms, if you save $1,000 in an IRA, and you are in the 32% tax bracket, you will save $320 on your current taxes. The tax on that income is deferred until you take the money out of the account. But since you will be retired then, your tax bracket may have decreased to 25%. So when, at age 65, you take the money out of the IRA account, you will only pay $250 in tax. While $70 of savings doesn't seem like much, you are likely to have saved much more than $1,000 by the time you retire. If you save $100,000, your savings will be $7,000!
Another potential advantage of an IRA is that you have the freedom to choose which investments you would like to make with your money. One restriction with an IRA is that you must begin taking withdrawals from your IRA by age 70 and a half.
If your household income is less than $167,000, or $105,000 if you are single, you may want to contribute to a Roth IRA instead of a traditional IRA. While contributions to a traditional IRA are tax deferred, you get no current tax deductions for money put into a Roth IRA. But your money grows tax-free in a Roth IRA, so when you take out funds from the IRA, you are not taxed on that money or the interest it has earned.
Another difference between a traditional IRA and a Roth IRA is that a Roth IRA does not require you to withdraw funds from your IRA at age 70 and a half. If you are employed, you can even continue to contribute money into that account.
A 401(k) plan is a great tool to start saving for retirement. It allows you to take money out of your paycheck before taxes and put it into an investment account. You are not taxed on this money until you take it out of the 401(k) account, hopefully when you retire and are in a lower tax bracket.
Your employer may also provide matching funds, up to a certain percent of your income. The money your employer contributes to your 401(k) account is not automatically yours. You have to be "vested." To be vested, you have to stay with the company for a certain length of time according to the schedule your employer determines. After that time, any money your employer contributes to your 401(k) money is yours.
One more important fact about 401(k) funds - if you decide to withdraw your money before you retire, you will pay a 10% penalty to the IRS and be taxed on that money. So only withdraw money from a 401(k) as a last resort! Your employer may allow you to borrow money from your account, without penalty. You will, however, pay interest on the loan. But the interest goes right back into your account so you don't actually lose any money in borrowing. Borrowing will slow down your investment growth.
Self-employment offers special challenges but also special advantages in saving for retirement. A Keogh plan is a tax-deferred retirement plan, similar to a 401(k), except that it is geared toward self-employed individuals. If you are self-employed, you can contribute up to $49,000 per year to a Keogh plan.
There are two different Keogh plans to choose from: a profit sharing plan, with a variable contribution rate and the availability of in-service withdrawals, or a money purchase plan, with a fixed annual contribution rate.
Self-employed people may choose instead to set up a Simplified Employee Pension, also known as a SEP-IRA, to which they can contribute 25% of their income, up to $49,000 a year. The SEP-IRA does not require special paperwork and annual filings, and so it is a less cumbersome alternative. Also available to small-business employers with employees are SIMPLE plans and SIMPLE 401(k) plans. Check with your tax adviser to see which type of plan would be best for you and your business.