IRA (Individual Retirement Accounts) and 401(k) programs are vehicles

IRA (Individual Retirement Accounts) and 401(k) programs are vehicles for retirement investing that may offer you tax breaks. Your income, your tax liability, and your tax filing status determine which of these accounts will be most advantageous for you financially and the most tax-wise. As company-sponsored pensions become a thing of the past, understanding IRA and 401(k) options is more important than ever in planning for a secure retirement.

Types of IRAs

There are a number of different types of IRAs, all with different tax advantages and eligibility requirements:
· Traditional IRA
Eligibility is determined by income. Annual contribution limits are established by the tax code. Annual contributions are tax deductible.

· Roth IRA Eligibility is determined by income, and income also determines your annual contribution limit. Contributions are made after taxes (i.e., are not tax deductible).

· SEP IRA Small businesses with one employee or more can set up a SEP IRA. Contributions are based on a percentage of net income.

· SIMPLE IRA Small businesses with a reliable and constant income stream are best suited for this IRA. Yearly contribution limits are established by the tax code. The SIMPLE IRA is an employer-sponsored contribution plan, much like the 401(k).

401(k) Plans

The 401(k) is an employer-sponsored plan. It sometimes includes a “match,” meaning that the employer will match a percentage of the employee’s contributions. Yearly contribution limits are defined by the IRS tax code. The 401(k) may include a pool of funds to choose from, much like a mutual fund, except that you have choices within the parameters of the plan as to how you want to allocate your contributions.

Types of 401(k) Plans

Your employer may offer you the following 401(k) plans:

· Regular 401(k) This is much like a traditional IRA. Contributions are tax deductible. Contributions and earnings are taxed upon withdrawal.

· Roth 401(k) Much like the Roth IRA, contributions to a Roth 401(k) are post tax (i.e., not tax deductible). Earnings and contributions meeting particular qualifications (i.e., withdrawn after age 59-1/2, or other qualifying circumstances) can be withdrawn tax free.

Tax Advantages of Contributions to a Traditional IRA

If you qualify to contribute to a traditional IRA, you will be able to deduct your yearly contribution from your taxes. You will pay tax on the contributions (as well as all additional earnings) at retirement, but if you expect to be in a lower tax bracket at retirement, it may be advantageous for you to take the tax deduction now.

Tax Advantages of Contributions to a Roth IRA

Contributions to a Roth IRA are post tax, meaning that you don’t get to deduct your yearly contribution on your taxes. However, contributions as well as earnings on the contributions can all be withdrawn tax free at retirement. If you expect to be in a higher tax bracket in retirement than during your working years, the Roth IRA may make sense as an investment vehicle, provided you meet income and filing eligibility requirements.

Tax Advantages of Contributions to a Regular 401(k)

If you are fortunate enough to work for an employer that offers a 401(k), there may be several tax advantages, depending upon your financial situation. All contributions to a regular 401(k) are tax deductible, and the yearly limit for contributions has been higher than that for IRAs. Contributions are taxed upon withdrawal. A regular 401(k) makes sense if you believe you will be in a lower tax bracket at retirement. Some 401(k) sponsors match a percentage of employee contributions – essentially “free money” for you.

Tax Advantages of Contributions to a Roth 401(k)

The Roth 401(k) works like a hybrid of the regular 401(k) and the Roth IRA. Yearly contribution limits are the same as the regular 401(k), but Roth 401(k) contributions are all post-tax. Again, the employer may match part of your contributions. The Roth 401(k) offers tax-free withdrawal of earnings and contributions at retirement. Since the amount you can contribute to a Roth 401(k) is relatively larger than the yearly contribution limits for the Roth IRA, you can potentially save, and earn, a great deal of tax-free money if your investments perform well.

Tax Advantages of Contributions to a SEP or SIMPLE IRA

Contributions to a SEP IRA are completely tax deductible until withdrawn at retirement. The amount that can be contributed to a SEP is calculated based on your net profits for the year and your business filing status (sole proprietor, corporation, etc.). Contributions to a SIMPLE IRA are pretax, and therefore tax deductible in the year of contribution. Taxes are paid upon withdrawal at retirement. Yearly contribution limits to the SIMPLE IRA are usually lower than the limits for the 401(k), although administrative costs for the SIMPLE IRA are less than that of the 401(k).