Final answer:
Tax-deferred savings plans like Traditional and Roth IRAs allow for pre- or post-tax contributions and benefit from tax-free growth until withdrawal. 401(k)s, provided through employers, offer similar tax-deferred growth and the added advantage of being portable between jobs. Understanding the different features of these accounts is essential for retirement planning.
Step-by-step explanation:
Tax-Deferred Savings Plans: Traditional IRA, Roth IRA, and 401(k)s
Tax-deferred savings plans are essential tools for retirement planning. They offer various benefits, depending on the type of account. A classic example is an Individual Retirement Account (IRA), which can come in two forms: Traditional and Roth.
A Traditional IRA is funded with pre-tax dollars. This means that contributions may lower your taxable income in the year they are made. The funds then grow tax-deferred, and taxes are only paid upon withdrawal, usually during retirement when your tax rate might be lower.
The Roth IRA, on the other hand, is funded with post-tax dollars. The benefit here is that withdrawals at retirement are tax-free, provided certain conditions are met. This is particularly advantageous if you expect to be in a higher tax bracket when you retire.
Beyond IRAs, many workplaces offer 401(k) plans, which are also tax-deferred. Employers often contribute a fixed amount to these, with employees contributing as well through payroll deductions. These contributions reduce your taxable income, grow tax-deferred, and are taxed upon withdrawal.
Both IRAs and 401(k) plans have annual contribution limits, and tax laws can change, affecting these accounts. The key difference is that while anyone can set up an IRA, 401(k) plans are employer-sponsored and are portable if you change jobs. The investments in these accounts can potentially offset inflation by generating real rates of return.