Retirement Plans

Retirement plans allow you to earn money with tax deferrals, greatly increasing your earning potential. You should invest the maximum amount possible in retirement plans each year. There are two major types, 401(k)s and IRAs:

401(k)

A 401(k) is an employer based savings/retirement account with tax advantages. Income is deferred directly into the 401(k) account, and is not taxed until distributed (taken out of the account). Traditional 401(k) plans also allow employers to make matching, tax deferred contributions.

IRA

An IRA (Individual Retirement Account) is basically a savings or investment account for individuals, with great tax advantages. There are two types of IRAs:

  • Traditional IRA - A traditional IRA can be tax deductible, meaning you don't pay taxes on the money you add to your IRA account when you put it in. The earnings in the account are not taxed until you take the money out, or distribute it.

  • Roth IRA - A Roth IRA is similar to a traditional IRA, but the tax situation is reversed. With the Roth IRA you do pay taxes on the money you put into the account, but you don't pay taxes on earnings even when you distribute them.

Converting Traditional IRAs to Roth IRAs

In the past there have been income restrictions on Roth IRAs, meaning that people making above a certain income could not make Roth IRA contributions. As of 2010 this has been eliminated. (Roth IRAs are a better deal since taxes are not paid on earnings when distributed from the Roth.) Therefore, if you have traditional IRAs and can afford the taxes associated with taking the money out, you may do better to convert your traditional IRAs to Roth IRAs. There are a couple of exceptions however. If you expect to pay significantly lower taxes after retirement due to a reduction in income, the benefit of the conversion may be canceled out. If you expect to pay higher or the same tax rate, then you should make the conversion if you can afford it.

Converting 401(k)s to Roth IRAs

Upon retirement or when moving from one job to another, you have the option to convert your 401(k) to an IRA. In general this is a good idea. IRAs normally give you far more investment options, and Roth IRAs have even more benefits. With a traditional IRA you must take distributions when you turn 70.5 years old. With a Roth IRA you never have to withdraw your earnings, so if you choose you can pass on the tax-free distributions to your children. As these decisions aren't simple, primarily due to complex IRS tax code, you may be better off talking to a financial advisor before making your decision.