American tax law structures itself to encourage people to contribute to voluntary retirement accounts. The most popular is the Individual Retirement Account, widely called the IRA. Several types of IRAs are available, each with different rules and different benefits.
A traditional IRA involves an investment, often annually, of pre-tax dollars. The IRA can be dedicated to a variety of investments. Examples are certificates of deposits (CDs), regular interest-bearing bank accounts, and investment accounts for the purchase of stocks, bonds or mutual funds. The amount added to the account each year is not subject to income tax that year, nor is any capital gain or interest earned in any particular year. The taxpayer only pays tax for withdrawals later on. Deferring tax has financial value in itself, plus, on retirement, many income earners will realize their gains while in lower tax brackets than those they had when they were working. Before the age of 59 and a half, the holder of an IRA will pay extra penalties for withdrawals. After the age of 70 and a half, the holder will be required to withdraw (and pay tax on) a certain minimum annual amount.
A Roth IRA functions much differently from a traditional IRA. Here the investor uses dollars for each annual investment on which he or she has already paid income tax. In exchange, the distributions are not subject to income tax (as long as the account exists longer than five years and the investor is at least 59 and a half.) No mandatory distributions are required at any point.
In the case of both of the above-described IRAs, an owner may invest an annual maximum of $5000 (if over 50 years old, $6000). He or she may have both kinds of IRA but can combine contributions only up to the maximum, in other words, as an example, $2500 to each.
In order to allow small business to create retirement accounts for owners and employees parallel to those benefitting large corporations, the Internal Revenue Service has a system of SIMPLE (Savings Incentive Match Plan for Employees) and SEP (Simplified Employee Pension) IRAs. The SIMPLE IRA lets the employer contribute an amount equivalent to up to 3% of the employee’s income as a job benefit. SEP plans allow up to 25%. The employees (or business owners) decide how they want to invest the money.
Another popular retirement vehicle for employees is the so-called 401(K) plan. This plan allows employees to send a portion of their salaries to the plan every year, thus saving that year’s income tax on the amounts. As an incentive, employers may sometimes match a portion of their employees’ contributions. Like a traditional IRA, the money and its earnings do not go through the tax wringer until withdrawal time. If the employee takes out money before the age of 59 and a half, extra penalties apply, however. An outside administrator invests the 401(K) plan assets, although individual employees have some say in how their portions are allocated.
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