How Do I Make Sense Of Retirement Savings Plans?

If you don’t have the retirement savings you want, one of the barriers you face is likely to be understanding all of the crazy. Nonsense terms you think you need to understand just to open an account.

There are really just four key words to understand the retirement planning arena. That’s it. Four:

IRA: Individual Retirement Arrangements more commonly called IRA’s is accounts defined by the Internal Revenue Service (IRS) as having special status that excludes the income on the account from your taxable income each year (in some cases, only until you retire). You can open an IRA with virtually any bank, credit union, or brokerage.

401k: A 401k is much like an IRA, except that your employer opens the account and holds the money for you. You have the option of contributing some of your income into the 401k (you can’t be forced to participate) and the income from the investments in the 401k is excluded from your income at least until retirement.

Traditional: Both IRAs and 401ks come in two varieties. The first of which is called “traditional” because it was invented first. A traditional IRA or 401k is one in which your contributions to the account can be deducted from your current year’s income on your tax return. In other words, if you contribute $5,000 in 2012, that $5,000 will be deducted from your taxable income, reducing the tax you pay this year. Furthermore, you’ll pay no tax on any income earned in the account until you withdraw it for retirement income after age 59 1/2. When you withdraw it during retirement, you’ll pay tax on it then.

Roth: Again, both IRAs and 401ks come in the “Roth” variety. Roth variety accounts make the money in the account never, ever subject to tax, provided that it stays in the account until you retire. The catch is that there is no tax deduction for the year of your contribution, making it more difficult to get started.

If you have a 401k at work but don’t think you’re saving enough, you can simply contribute more to your 401k. Very few people bump up against federal limits on contributions to a 401k. You don’t need to have an IRA, too.

If you don’t have a 401k, go to virtually any financial institution and open an IRA. If you are likely to have more than $10,000 within a year, go to a stock brokerage like Schwab, Fidelity or TD Ameritrade. If it will take a few years, just get started at your local bank or credit union.

Traditional or Roth? If you pay a very low tax rate now, go with the Roth as your future income will likely be taxed at a higher rate and the deduction isn’t worth much this year. If you are taxed at a very high rate (congratulations, you earn a lot). You’ll likely want to contribute to traditional accounts. Still have questions? Your tax accountant and the folks at the bank or brokerage can help. Go sees them.