IRAs, short for Individual Retirement Accounts, share some qualities of the 401(k).
They're basically a retirement plan, but instead of selecting investment choices as offered by your employer, you can invest in any mutual fund, stock, bond or combination of investments that you want. You have to remember to send in a check to the investment company -- contributions can't be taken out of your paycheck. Today, there are two different kinds of IRAs -- the traditional IRA and the Roth IRA.
With a traditional IRA, you can set aside $3,000 per year in 2002 (contribution limits will go up each year, too -- see chart on page 4), and that contribution can be deducted from your adjusted gross income when tax time rolls around, as long as you meet certain income requirements. Singles who earn up to $33,000 a year and married couples who earn under $55,000 can fully deduct their contribution. If a single person earns between $33,001 and $42,999, or if a married couple earns between $53,001 and $62,999, they can only partially deduct their contributions. Any single person who earns more than $55,001 or married couples who earn more than $63,000 can still invest in a traditional IRA, but the contributions are not tax-deductible.
Like a 401(k), the funds in an IRA grow tax-deferred until you take them out at age 59 1/2 (otherwise you'll face taxes on the earnings and a 10 percent penalty for early withdrawal). When you do take out the money after age 59 1/2, you'll owe income taxes on the earnings.
That's where the Roth IRA parts from its older cousin. If you choose a Roth (named for Senator William Roth from Delaware, who spearheaded the legislation that created it in 1998), you can also save $3,000 a year in 2002 and the money grows tax-deferred. You can't take a tax deduction, though, because the Roth offers a bigger benefit -- you can withdraw the funds tax-free when you reach retirement age.
"You pay income tax now but it's like paying tax on the seed and the crop grows for free," says Slott. "The Roth IRA is so powerful because the money you take out is tax-free."
To show the big difference between the Roth and a traditional IRA, Slott gives the following example: Two 35-year-olds invest $3,000 a year -- one uses a traditional IRA and the other uses a Roth. They'll both have $367,038 over 30 years if the account earns an average of 8 percent. The person who invests in the traditional IRA will have to pay taxes when the funds are withdrawn, and after taxes, the account would only be worth $244,067 in the 27 percent tax bracket. The person who invested in a Roth will be able to keep the entire $367,038, tax-free. Of course, the person who saved in the traditional IRA was able to deduct contributions from their taxes each year, but planners agree those savings are small compared to the enormous tax-free growth of a Roth. The Roth also has income limits. To contribute to a Roth, singles have to earn less than $95,000 a year and married couples have to earn less than $150,000 a year.
So which type of IRA is best for you? That depends, of course.
"For a young person in their 20s, the benefit of getting the deduction from the traditional IRA is not going to touch the tax-free benefit of the Roth," says Lee. "If you qualify for the full deduction, then you have to look at how old you are. For someone who is younger, the Roth is a better choice in most cases."
Continued on page 4: Start Saving Now