What You Should Know to Start Saving for Retirement

So you've made the decision that you need to start saving for retirement. Great! That's the first step. But which way to go? Roth? 401(k)? IRA? The following is a basic primer on the different types of plans you should be familiar with to get started saving for your retirement.

401(k)

A 401(k) plan is an employer-sponsored defined contribution retirement plan. If you work for a company that offers 401(k) plans to its employees, you are generally eligible to participate. A 401(k) plan is one in which an employee contributes money directly from their paycheck. In most cases, the money contributed is pre-tax (which will also reduce your income tax), and the money in the account will grow tax-deferred, which means you will not pay any income taxes on the money in the account or on what you earn until you withdraw it. In many cases, an employer will also match part of your contributions, which is basically like getting a raise or free money. So if your employer has 401(k) plans and will match a part of your contribution, at the very least, you should contribute the minimum amount required to get the matching contribution.

There is an annual maximum contribution to your 401(k) retirement plan. The amount generally increases each year for cost of living. In 2008, the limit you can contribute is $15,500. This amount does not include the amount your employer matches. If you are over 50 years old, you may contribute an additional $5,000 to your retirement account.

Generally, you may not withdraw your money before age 59½ without incurring a 10% penalty.

Roth 401(k)

Since 2006, a new law allows employers to offer their employees a Roth 401(k) retirement plan. The difference between the Roth and the regular 401(k) account is that contributions to the account are after-tax, but when you withdraw the money, the money is tax free. But as far as I know, this option hasn't really taken off with a lot of employers because of the added administrative costs so I won't go into any more detail here.

Traditional IRA

An Individual Retirement Account (IRA) is basically a savings account for your retirement. You must open it yourself - your employer does not play any part in an IRA, and the funds come directly from you. Anyone who works or receives alimony can open an IRA. However, there is an age limit of 70½ on who may set up or contribute to an account.

There is a limit to how much you can contribute to your IRA. For 2008, the amount is $5,000. If you are age 50 or older, the limit is $6,000. Contributions can be made at any time during the year or by the due date for filing your tax return for that year. For example, contributions for 2008 can be made up until April 15, 2009.

With an IRA, you must start withdrawing funds by April 1 of the year you reach the age of 70½, but you can start withdrawing funds at age 59½. Any funds withdrawn before the age of 59½ are subject to a 10% penalty.

One advantage of the traditional IRA is that you may be able to take a tax deduction up to the amount of your contribution. However, in exchange of the tax deduction now, taxes will be incurred when you withdraw the funds from the IRA. This is what as known as tax-deferred - the taxes on the money and any earnings (interest, appreciation) will be deferred until you withdraw the funds. The IRA is available to everyone, with no income restrictions, but the amount of your tax deduction may be restricted based on income.

Roth IRA

The Roth IRA is similar to the traditional IRA. The primary difference between the two is that all the money and any earnings in the account generally grow tax free. That's right. No matter how large your account grows, because you contributed after-tax funds and didn't take any tax deductions when you made a contribution to the account, your money will generally grow tax free. Also, there is no mandatory distribution age, but you must wait until 59½ before withdrawing funds without penalty.

There are restrictions, however, as to who can open a Roth IRA account. In 2007, for single filers, the amount you can contribute will start to be reduced if your modified adjusted gross income (AGI) is at least $99,000, and if your AGI is $114,000, you cannot make a contribution to a Roth IRA. For married joint filers, the reduction starts at an AGI of $156,000, and you cannot contribute if your AGI is $166,000 or more. If you are not eligible for a Roth IRA because of these income limits, you can still contribute to a traditional IRA, but you may not be able to take the tax deduction.

Just like the traditional IRA, the contribution limit for 2008 is $5,000. If you are age 50 or older, the limit is $6,000.

For most people (and this is a broad generalization and only one person's opinion), if you have the option of a 401(k) with an employer match, then at the very least, you should open a 401(k) and contribute at least the minimum amount to get your employer's matching contribution. There is no excuse for not getting the free money your employer is offering for your retirement. If, however, you do not have a 401(k) available to you, then for many people, I think the Roth IRA is a very good option. Although it does not offer tax deductions now, your account will hopefully keep growing and growing, and in a Roth IRA, you will be able to withdraw the funds without paying any more taxes on them. I don't know about you, but I'd rather pay taxes now in exchange for tax free money later. Who knows what income tax rates will be like by the time you retire?

I know. It's all very confusing, and there are exceptions and rules that I cannot even begin to explain here. Hopefully, though, this article has at least given you a basic understanding of the differences between the primary types of retirement accounts available and has provided a foundation to start your own retirement planning. Everyone's needs are unique, but unless you have a secret trust fund, everyone also needs to start saving for retirement, no matter how old you are. It's never too early to start, and if you feel it's too late, it's not. The important thing is to start saving, no matter how little or how much you have. So what are you waiting for?