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Preparing for Retirement > The Best Ways to Save - Make IRAs and 401(k)s Grow

The Best Ways to Save — Make IRAs and 401(k)s Grow

by Coeli Carr

Ask financial planners the best way to save for the future and they'll give you the same answer: savings plans with tax advantages. Yet saving is a challenge for many people who have trouble keeping up with day- to- day expenses. They're concerned that if they put money away it won't be readily available.

"What a lot of people don't realize is that the tax advantage is a tool that helps people reach their longterm goals that much sooner," says John McCarthy, a certified financial planner in Spokane, Washington.

Experts advise putting even small amounts in a tax-advantaged account to help secure a person's long-term financial picture. After all, the money saved and the interest earned are not taxed until the individual starts to withdraw it at age 59-1/2 or older.

To make the most of these tax-advantaged savings plans, it helps to know how they work.

401(k) Plans

Many companies provide a 401(k) plan for their employees. At nonprofit organizations, it's called a 403(b), and public employees have a 457(b) plan. In 2005, employees could contribute a maximum of $14,000 to their plans, to be invested in the options available through their particular plan. Starting in 2006, the maximum contribution increases to $15,000. People age 50 and older could contribute an additional $4,000 "catch-up" amount in 2005.

Many larger employers will match the amount of money that employees save, up to 6% of their income. McCarthy advises workers with 401(k) plans to contribute enough money to receive the match "because it's free money."

Individual Retirement Accounts (IRAs)

With an IRA, individuals save money on a taxdeferred basis to be invested in various types of mutual funds or directly in stocks -- up to $4,000 in 2005. IRAs also have a catch-up benefit. For single people over age 50, the amount is $500 for 2005, which increases the maximum to $4,500. In 2006, the catch-up amount is expected to go up to $1,000.

Even if individuals contribute to their company's 401(k) plan, it's still possible to put additional earnings aside?as much as $4,000 a year?through an IRA. Single individuals must have a gross income of less than $50,000 to qualify for this supplemental IRA contribution; for married couples, the maximum is $70,000.

Roth IRAs

This tax-advantaged savings plan works differently than a 401(k) or a traditional IRA, where the money saved is not taxed until it is used. With the Roth IRA, you pay taxes up front and must hold the account for at least five years while your earnings grow tax-free. The benefit? You won't be taxed when you tap into the Roth IRA at age 59-1/2, provided you've had the account for five years.

To open a Roth IRA, single individuals must have an income of less than $95,000 and married couples must earn less than $150,000. The contribution maximums and catch-up opportunities are the same as for the traditional IRA.

Early Withdrawals

Under most circumstances it is not advisable to make early withdrawals or borrow against a taxadvantaged account, according to financial consultants. Not only will you pay a 10% penalty on the amount you withdraw, but you will also have to pay federal income tax on that amount.

Jeffrey Rattiner, a certified financial planner in Centennial, Colorado, says too many people see a lump sum of money sitting in their accounts "as a great source of money" and decide to borrow it. But if they do, they won't have that money when they're ready to retire.

People who withdraw money from their IRA have 60 days to repay it or replace it before receiving a penalty. And if they take a loan against their 401(k), they still have to pay the amount back to themselves, along with the interest, within a set period of time.

There are instances, however, when it is necessary to make a withdrawal, and there are provisions that make that possible. First-time home buyers can take out as much as $10,000 from their IRAs without incurring a penalty. And people age 55 and over who lose their jobs can also withdraw their 401(k) money without a penalty. Another exception allows people under age 591/2 to withdraw any amount of money from IRA plans under special circumstances, such as death or disability.

Preparing for Retirement

Having the financial resources to build a comfortable retirement is important, say financial planners. To get there, McCarthy suggests, you should either increase income or decrease expenses. "Get a second or third job, if necessary, or adjust your lifestyle," he says. Did you receive an income tax refund? Funnel it into an IRA, for example. "A lot of people take the refund and spend it on some toy instead of reinvesting it," he says.

A direct relationship exists between how much money an individual saves today and how much he or she will have to live on during retirement. With this in mind, financial consultants say the benefits of investing in a tax-advantaged savings plan are too great to pass up.

Adapted from Today's Focus, Winter, 2006.

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