Taking advantage of government tax shelter arrangements like the 401k ira and Roth ira, gives your savings room to grow faster and larger. Each program has different attributes which allow a person to find one matching their financial needs.
401k
Classified by the IRS as a section 401 (k,) this is a tax-deferring plan entered into through an employer. The employee who chooses this plan contributes a percentage of every paycheck up to a maximum designated percentage. This plan has dual advantages; the amount taken from your pay is not taxed, nor are they entirely claimed as taxable income. The government still counts these contributions when calculating the amount of social security, Medicare, and unemployment tax you owe, and distributions are considered regular income for tax purposes.
For a 401 (k) performing well, the dual absence of taxation can result in an impressive nest egg. Access to this nest egg without penalty is not allowed until the age of 59 1/2, however, and there are regulations limiting annual contributions. For 2010, this limit is $11,500 if you are under 50, and for those over 50, you are permitted an additional $5,500 in ‘catch-up contributions.’ One rule the IRS specifies about these catch-up deposits is they can not exceed the amount of the annual contribution for the year.
As with a traditional ira, the owner must begin taking money out by the age of 70 ½, or face a 50% penalty. Unlike a traditional retirement arrangement, if the employee is still working, they are not required to take distributions.
Traditional IRA
With the employer sponsored retirement plan, the employee can receive matching amounts from their employer every time they contribute to their 401 (k.) Not so with the traditional arrangement, and as previously mentioned, even if the person is still working they must beginning accepting payments by the age of 70 ½.
The other advantage to the 401 (k) is the available loan system. If a person needs access to their money, they can take a loan out against their savings. The owner of the account will then be paying the money back, but avoiding a 10% penalty and income tax. There are exceptions to early withdrawal penalties for the traditional ira, however. These include using money for purchasing a home or higher education, to name two. With both plans, early distributions can begin if the person becomes disabled.
Conversions
The 401k is set up through an employer, so the plan ceases when the employee is no longer working. To ensure their money is still growing for retirement, it can be rolled over to a traditional ira or Roth ira. The rollover money is taxed in the year of the conversion, but if moved into a Roth, the liability can be divided between 2010 and 2011.
The main differences between traditional and Roth are how they are taxed and when the owner must take distributions. For estate planning, the Roth has the advantage. Money deposited does not have to be taken out by a certain age. The caveat is that the money is taxed as income the year it is contributed.
The IRS has simplified the process of moving money from one type of account to another, so the important point is to get started; the earlier you start, the more your money will grow.
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