Income taxes can take a serious bite out of your savings and investment plan. Fortunately, the federal government is well aware of this, and gives taxpayers a break in the form of several IRS-approved tax-deferred investment plans. These investment vehicles allow you to put money away for your retirement and not pay any taxes on your gains until you begin to make withdrawals when you’re in your 50’s or later. This allows the magic of compound interest to go to work for you, earning you interest on top of interest. It’s an extremely effective way of building your financial nest egg.
With an Individual Retirement Account (IRA) you can invest up to $4,000 per year in virtually any type of security instrument you choose, from a bank Certificate of Deposit to individual stocks to mutual funds. Just tell the financial institution that you want your investment to be sheltered in an IRA. You must report your investment on your tax return, but you don’t have to pay any taxes on your gains until you begin to withdraw the funds at retirement age. If you have a spouse who doesn’t work, you can also open a Spousal IRA and contribute up to an additional $4,000 per year into it.
The 401(k) is a qualified plan (which means it meets the requirements of the Internal Revenue Code) that’s established by employers into which eligible employees can make salary-deferral contributions. In other words, the contribution comes directly off the top of your paycheck without your ever seeing the money. This makes saving and investing automatic, eliminating the need for you have to decide if you’re going to save each month. The biggest benefit of a 401(k) plan is that many employers will either match or partially match your contribution, which means you get a pretax investment, tax-deferred compounding of your interest earned, and an extra addition to your principal from your company (essentially, free money). This allows the value of your investment to grow at an even faster rate. Nonprofit employers offer a similar plan called the 403(b). It’s basically the same arrangement as the 401(k); the difference in name derives from it being part of a different section of the Tax Code.
An Annuity is a bit like a combination of an IRA and a life insurance policy. Like an IRA, an annuity allows you to earn interest and capital gains on your investment without paying any taxes until you begin to withdraw the funds at retirement age. And like an IRA you’ll face a 10% penalty if you withdraw before your eligible age. But unlike the IRA, you can make virtually unlimited contributions yearly. Those contributions, however, are with after-tax dollars, so you don’t get the tax deduction benefit that’s available with the IRA or 401(k). But since an annuity is basically a quasi-insurance vehicle, once you begin withdrawing your money (or, annuitizing), you’re guaranteed to receive an income for the rest of your life. In other words, you’ll never outlive your retirement funds.
