Tax deferred retirement accounts are beneficial because the taxes on account contributions and earnings are postponed until the money is withdrawn from the account instead of being paid in the year the growth takes place. For example, if you contribute $5,000 to a tax deferred account, you may be able to deduct the amount of the contribution from your taxes and any interest on the account will not be taxed until you take a distribution from the account at retirement. The downside to these accounts is that there is usually a significant penalty if you withdraw the money before retirement.
Traditional IRAs are open to anyone age 70-1/2 or younger who has taxable income. The annual contribution limit for 2009 is $5,000 for people under age 50 and $6,000 for people age 50 and older. Contributions to a traditional IRA are always tax deductible if neither you nor your spouse are covered by employer-sponsored retirement plans or if your income is below the limits for taking the tax deduction if you are covered. These limits change annually and are adjusted for inflation. You are not responsible for paying any taxes on a traditional IRA until you take distributions from the account.
Traditional 401(k) plans are offered through employers to their employees. The limit for your annual contributions is significantly higher than for an IRA. For 2009, you can contribute up to $16,500 if you are under 50 and $22,000 if your are 50 or older. These contributions are usually made with pre-tax dollars, meaning you do not report the contributions as income on your tax return. If you make contributions with after-tax dollars, those contributions are deductible on your taxes. Like the IRA, you pay no taxes on the traditional 401(k) until you take distributions at retirement.
Individuals who work in public schools and other nonprofit businesses can invest in a 403(b) plan. These plans are similar to 401(k) plans in that you must contribute through your employer instead of having the plan on your own like you would with an IRA. Like the IRA, you pay no taxes until you take distributions at retirement.
IRC 457(b) Deferred Compensation Plans
IRC (Internal Revenue Code) 457(b) plans are available for employees of selected state and local governments and some tax exempt non-government groups. IRC 457(b) plans are functionally very similar to 401(k) and 403(b) plans. They have the same contribution limits and the money and earnings in the account are not taxed until they are withdrawn.
Thrift Savings Plans
Employees of the federal government are not eligible to contribute to 401(k) plans so the government developed the Thrift Savings Plan. The plan functions the same way as a 401(k) with the same tax advantages and contribution limits except that the plan is administered by Federal Retirement Thrift Investment Board.
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