Qualified retirement plans offer a variety of tax benefits to save for your post-working years. Some options, such as 401(k)s, are only available if your employer offers them. However, other plans, including individual retirement arrangements -- more commonly called IRAs -- are created independent of your employer. All of these plans require that you have compensation to contribute. Traditional IRAs and 401(k)s also require that you be under age 70 1/2, while Roth IRAs require that your income falls below the annual limits for your filing status.
The higher contribution limits allow you to sock away a lot more money each year in a 401(k) plan than an IRA. In addition, 401(k) plans permit employer contributions whereas traditional and Roth IRAs only allow you to contribute. As of 2012, 401(k) plans can accept up to $50,000 ($55,500 if you're 50 or older) of contributions between the employee and employer combined. The contribution limit for traditional and Roth IRAs is only $5,000 ($6,000 if you're 50 or older), although this will rise to $5,500 and $6,500 in 2013.
Contribution Tax Treatment
Contributions to both 401(k) plans and traditional IRAs can reduce your taxable income in the year of contribution. Roth IRAs, on the other hand, don't offer a deduction for contributions. However, once the money is in any of the accounts, it grows tax-free until you take distributions. You pay taxes on retirement withdrawals from 401(k) and IRA plans, but Roth withdrawals are tax-free.
The rules for qualified withdrawals for traditional IRAs and 401(k)s are easy: If you're 59 1/2 or older, it's a qualified withdrawal. It's still taxable, but you won't owe any penalties. For Roth IRAs, you must wait at least five years from Jan. 1 of the first tax year you contribute to a Roth account and you generally must be either 59 1/2. When you take a qualified Roth IRA distribution, it's all tax-free. If you take an early distribution, your contributions come out tax-free since you've already paid taxes on them, but your earnings are taxed and may face penalties for early withdrawal as well.
Penalties and Exceptions
For any of the three plans, if you take a non-qualified withdrawal, you'll pay an extra 10 percent penalty on the taxable portion of the withdrawal. Certain penalty exceptions apply to either 401(k) or IRA distributions. For example, a permanent disability gets you out of the early withdrawal penalty for either an early 401(k) or IRA distribution. A distribution after you leave your job when you're 55 or older is penalty-free for 401(k)s, but not for IRAs. On the other hand, higher-education expenses and up to $10,000 to buy a first home will get you out of the penalty for IRAs, but not 401(k)s.
Traditional IRAs require you to start taking minimum distributions in the year you turn 70 1/2. Typically, 401(k) plans require the same. However, if you're still working, you can postpone the start of required distributions until the year you retire. Roth IRAs don't require minimum distributions unless you've inherited the account.
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