Retirement plans are arrangements to provide people with an income after retirement. The most common private retirement plans are IRAs and 401(k) plans. Also, some large businesses provide pensions to their employees and pay them a monthly amount depending on the length of employment.
One of the main reasons people have IRA and 401(k) is to reduce their tax liability and taxable income which allows them to save more in the long run.
Individual Retirement Accounts (IRA) can be either employer provided or self-provided, and give certain tax benefits. Contributions are made to the account and the IRA owner can invest this money in most types of securities. The money is held by a custodian, usually a bank or brokerage firm, and the custodian does the actual investing based on directions from the IRA owner. Transactions inside the account, such as interest and capital gains, are not taxed.
There are two main types of IRAs:
- Traditional IRA – Allows you to contribute a certain amount each year and invest your contributions without being taxed on the annual investment gains(which helps you grow more). This tax break provides an immediate advantage, however at retirement it is only beneficial if the holder is in a smaller tax bracket. Withdrawals cannot begin until age 59Â½ or a 10% fee is charged, and once withdrawlas begin there is a minimum annual withdrawal.
- Roth IRA – Contributions are made after being taxed but withdrawls are made free from income tax, including most earnings from the account. There are also fewer restrictions and requirements on withdrawls.
An IRA is basically an investment account in which you can make contributions from your income without being taxed annually for your capital gains. Some benefits of Traditional IRA are:
- Contributions are tax-deductible
- Earnings and gains are not taxed allowing investments to grow
- Anyone with an earned income can contribute to a IRA account
- You may use contributions on investment options such as mutual funds, stocks, bonds, CDs
Another benefit to traditional IRAs are that contributions made are tax deferred and you are not taxed and withdrawals that are made years later in retirement reduce your tax liability. Since income is often lower during retirement years, funds withdraw may be subject to a lower tax bracket.
A 401(k) plan is an employer sponsored retirement plan. A part of the employee’s wages are deferred into the account and the employee selects from a number of investment options. Some companies also match employee contributions to some extent and pay extra money into the account. The contributions are not taxed, and gains from investments in the 401(k) account are not taxable events, so no capital gains tax or interest tax is applied. When money is withdrawn it is taxed as income, however. Like IRAs, money withdrawn before age 59½ is subject to a 10% fee.
Both 401(k) plans and IRAs have specific eligibility requirements and contribution limits. Also, most plans allow for early withdrawl without a penalty in certain situations that constitute hardship.
The benefits of 401(k) is that they allow you to save money toward retirement on a tax-deferred basis. That means that you do not pay federal or state income taxes on your savings or the investment earnings until you withdraw at retirement. SInce your taxable income at retirement is much lower than when you are earning a salary working, your tax liability is much lower.
In addition, when money is deducted from your paycheck before taxes are withdrawn, this would lower your taxable income and therefore lowers your taxes.
The different retirement plans can be complex and difficult to understand. A tax attorney can help you understand the tax implications of each plan and help you determine which plan is best for you.