Under federal tax law you can make annual contributions into Individual Retirement Arrangements, and those contributions grow on a tax-deferred basis. However, there are several types of IRAs, and each type of account has its own rules. Before establishing an IRA, you should determine which type works best for you.
Traditional IRAs work similarly to 401k accounts, in that your contributions are made on a pre-tax basis. You must have earned income in order to start an IRA, but both your contributions and the account earnings grow tax-deferred. As of 2011, people who are 50 or older can deposit up to $6,000 per year into Traditional IRAs, while people under 50 can contribute up to $5,000. Your contributions to Traditional IRAs are bracketed together with your 401k contributions, so if you contribute fully to your 401k you cannot always contribute to a Traditional IRA.
You deposit already taxed funds into a Roth IRA, but you can avoid paying any taxes on the account earnings if you keep the account open for at least five years and make no withdrawals until you reach age of 59 1/2. The ability to make eventual tax-free withdrawals makes Roth IRAs very appealing, but income restrictions apply, and high earners cannot contribute to Roths. You can however convert funds held in a Traditional IRA into a Roth by paying income tax on the entire amount that you transfer. No income restrictions apply to these Roth IRA conversions.
Non Deductible IRAs
Non deductible IRAs work in exactly the same manner as Traditional IRAs except you fund the account with after-tax money. Your account grows on a tax-deferred basis, but you pay ordinary income tax on your earnings when you make withdrawals. These accounts are sometimes used by people who cannot contribute to a Traditional IRA because they already contributed to a 401k or earn too much money to contribute to a Roth IRA. However, Non Deductible IRAs are generally seen as the least attractive IRA option since you do not get an upfront tax deduction, and you do not avoid the taxes when you make withdrawals.
Many companies make matching contributions to 401k accounts. If this applies to your situation you are probably best advised to contribute to a 401k rather than a Traditional IRA and start a Roth IRA with any surplus funds, assuming you are eligible to contribute. However, if you withdraw from a Roth prior to age 59 1/2, you pay a 10 percent tax penalty and income tax on your earnings. You also pay a 10 percent penalty when you make withdrawals from Traditional IRAs, 401ks and non-deductible IRAs. Therefore, make sure you only invest money that you can truly afford to set aside for retirement.