How to Invest My Own Earnings for Retirement
Historically, the security of Americans' retirement incomes relied on a "three-legged stool" - a metaphor common among planners and government officials dating back to the early days of Social Security. The three legs were guaranteed employer pensions, private savings and investments, and Social Security. In recent years, however, the number of workers covered by traditional defined-benefit pensions has fallen dramatically. And fiscal pressures rooted in a combination of low interest rates and a large number of baby-boomer retirees may force the government to raise the retirement age, increase FICA taxes or increase taxes on Social Security benefits or both.
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Debt Reduction
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Generally, reducing or eliminating high-interest consumer debt is the first step toward retirement security. Under current law, interest on credit card debt is not tax deductible, and credit card interest rates and penalties can cause effective rates to zoom to 29 percent and higher. Even more modest credit card interest rates of 10 and 12 percent are enough to overwhelm any expected returns from retirement accounts. Left unchecked, credit card and other consumer debt balances will compound faster than retirement savings.
Workplace Retirement Plans
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Many companies sponsor retirement vehicles such as 401(k) plans. 401(k) plans let you defer a portion of your income and invest it for retirement, tax-deferred. That is, you invest with pre-tax dollars, and the account grows tax-deferred until you reach retirement age. Many companies offer to match a percentage of your own contributions -- frequently 50 percent up to three percent of your income. This is for long-term money; the IRS could charge you a 10 percent fee if you withdraw funds prior to age 59 and a half. If you work for a nonprofit or educational institution, you may be able to contribute to a similar retirement savings plan called a 403b.
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Traditional IRAs
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The IRA, or Individual Retirement Arrangement, allows you to make tax-deductible contributions toward a retirement savings or investment account. Depending on your income, you may be able to contribute up to $5,000 per year. If you are over age 50, the IRS also allows you to make an additional $1,000 per year in "catch-up" contributions. The IRS imposes strict income limits on eligibility, however. See IRS Publication 590, Individual Retirement Arrangements, for specifics on income limitations.
Withdrawals are taxed as ordinary income, and the IRS generally imposes a 10 percent penalty on early withdrawals except for certain emergencies, educational expenses and up to a $10,000 down payment on a first home.
Roth IRAs
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Roth IRAs do not generate a tax deduction in the current year. But the principal grows tax-free and income after age 59 and a half is tax-free as well. The IRS does impose a 10 percent penalty on early withdrawals, but allows for exceptions similar to those for traditional IRAs, listed above.
Again, the IRS does impose income limits on eligibility, though they are not as low as those for traditional IRAs.
Annuities
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Annuities are insurance products designed to generate a stream of income, either immediately or commencing at a future date (deferred annuities). They can promise a fixed, guaranteed return or they can be variable. All annuity contracts, however, involve the investor exchanging a lump sum or series of premium payments in exchange for the promise of a stream of income in the future. Annuity contributions outside of retirement accounts are made with after-tax dollars but grow tax-deferred. When you begin to take the income, part of the payment is your own principal returned to you, tax-free, and part is taxed at ordinary income-tax rates.
Mutual Funds
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Mutual funds can be held within retirement accounts or outside of them in taxable accounts. If they are in taxable accounts, you don't get a tax deduction or tax deferral. But if you hold them longer than a year, you are taxed at lower long-term capital gains tax rates rather than as ordinary income. Long-term capital gains rates are scheduled to rise in 2011 to 20 percent from 15 percent currently, while income taxes may rise, too, unless Congress first intervenes.
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