Dear Carrie: I'm trying to be smart about investing for retirement, but all the different accounts out there confuse me. Help! --A Reader
Dear Reader: I believe saving for retirement is one of the smartest things you can do, so kudos for asking this question. You're right that there is a confusing array of retirement account choices out there, but the good news is that they all have benefits that can help you save. There's no right or wrong choice -- only the choice that makes sense for your personal situation.
One good way to understand your choices is to look at the tax characteristics of different accounts.
TAX-DEFERRED ACCOUNTS GIVE YOU UPFRONT BENEFITS
Probably the most well-known retirement accounts are the 401(k) and the traditional IRA. These are tax-deferred accounts, which means you won't pay income taxes until you withdraw the money, preferably when you're retired. At that time, you'll pay taxes at your ordinary tax rate. (Note: You generally will be charged a 10 percent penalty on top of income taxes if you make a withdrawal before age 59 1/2.)
Now let's look at the different types of tax-deferred accounts. Here are some of the most common:
--(SET ITAL) 401(k) (END ITAL)--This is offered through an employer. You designate a percentage of your pretax income (meaning that you won't pay taxes on this money) to be automatically deposited into your account each month. Often an employer will match a percentage of your contribution. You then generally have a choice of investments. The current maximum annual contribution is $17,000 ($22,500 if you're 50 or over). You are required to start taking annual distributions at age 70 1/2. Nonprofits and tax-exempt organizations offer similar accounts, such as a 403(b) and a 457, which have the same general characteristics.
--(SET ITAL) Traditional IRA (END ITAL)--This account is available to individuals with earned income or their spouses. The maximum yearly contribution is $5,000 ($6,000 for those 50 and over). You may get an upfront tax deduction, depending on your income and whether you are part of an employer-sponsored plan. You can only contribute to a traditional IRA up to age 70 1/2. Like a 401(k), at 70 1/2, you're required to start taking annual minimum distributions.
--(SET ITAL) SEP-IRA, SIMPLE-IRA, Individual 401(k) (END ITAL)--If you're self-employed or own a small business, you have a choice of several tax-deferred retirement accounts depending on your circumstances. Annual contribution limits vary but are generally higher than a traditional IRA.
TAX-FREE ACCOUNTS GIVE YOU A BREAK DOWN THE ROAD