You're ready to start saving for retirement. That's great, but how should you go about laying the groundwork for your financial future? 401(k)? IRA? What do these terms mean? Here we'll look at these common questions and help you start saving for your life after work.
401(k) Plans
A 401(k) is fast becoming the most common method of retirement savings for Americans. These employee sponsored plans allow employees to contribute a percentage of their pay to a designated account. Most 401(k) plans are primarily designed around a family of mutual funds from which the participant can choose to allocate contributions. A 401(k) has two main benefits over a personal savings account. First, contributions to a 401(k) are taken from pre-tax income, which lowers tax liability. The second attraction is that 401(k) funds grow tax-deferred - no tax is due on these funds until they are withdrawn from the account. This means more money working for you in your retirement plan that would otherwise be going to federal and state income taxes.IRAs
\r\nAn IRA (Individual Retirement Arrangement) is simply an account that is designated for retirement savings. These accounts are offered by many financial institutions and contributed funds can be placed into a wide variety of investment vehicles ranging from FDIC insured Money Market Accounts to CDs to uninsured Mutual Funds and common stocks. There are two primary types of IRAs: traditional IRAs and Roth IRAs. The big difference between the two is how earnings are taxed. As with a 401(k), contributions to a traditional IRA grow tax-deferred. Contributions to a Roth IRA grow tax-free - after age 59-1/2 withdrawals from a Roth IRA are not taxed. More information on traditional and Roth IRAs can be obtained from the IRS IRA Resource Guide.Basic Strategy
When saving for retirement it's best to make use of tax-advantaged accounts specifically designed for retirement savings. If your employer offers a 401(k) savings plan and matches a percentage of contributions, be sure to take advantage of this program. Become familiar with your company's 401(k) policy and contribute at least the minimum amount required to get the full company match - any less and you're passing up free money. The free money here is your company's contribution to your savings account and it's the reason any 401(k) plan that offers a match should be the first stop in your search of savings options.Next look to an IRA. If your employer doesn't offer a 401(k) savings plan then the possibility of tax-deductible contributions to a traditional IRA make this an attractive option. Otherwise the tax-free growth offered by the Roth IRA may be a better choice. For 2005, the limit for contributions to an IRA is $4,000.
Looking to save more? Once you've contributed the maximum amount to your IRA go back to your 401(k) plan. Only after you've completely exhausted both options should you look to taxable accounts to grow your nest egg.