Income Tax Rates

Retirement plans benefit from special tax advantages but also are subject to special restrictions. For instance, there are rules that allow tax breaks for contributing to retirement plans and rules that allow retirement plan income to grow on a tax-deferred basis, but there also are rules that limit annual contributions and rules that dictate the timing and amount of distributions you take from those plans.

Before you can start planning, review the retirement plans that are currently available to you. Generally, there are two categories into which all plans can be sorted: IRAs and employer-sponsored plans. IRAs are perhaps the most widely used retirement plans because they're easy to set up and maintain. You can open up one yourself it doesn't have to be sponsored by your employer and you can contribute as much (or as little) as you want, whenever you want, provided you don't exceed applicable annual limits. Following are descriptions of the three main types of IRAs:

Traditional IRA. With this type of IRA you are able to let your assets grow on a tax-deferred basis. This is advantageous because you will not have to pay taxes on your assets until you withdraw funds from your account.

Contribution eligibility depends on earned income, statutory limits, and age. You can only contribute, at a maximum, as much as your earned income. Earned income is defined as income from wages and self-employment income in the period of one year. Earned income does not include investment income. If you are age 50 or older then you may also be allowed to contribute what are called catch-up contributions. Additionally, your spouse can also use your income to make contributions of his or her own. However, you and your spouse are only eligible for make contributions if you have not reached age 70 at the end of the year of the said contribution.

Before contributing to a traditional IRA, be sure you wouldn't be better served by contributing to another IRA type, such as a Roth IRA, or to an employer's 401(k) plan.

One factor that may affect your decision is the deductibility of your contribution. Your income level and other factors will determine if your contribution to a traditional IRA will be fully deductible. If neither you nor your spouse is eligible to participate in an employer-sponsored plan, your contribution is deductible no matter how much income you earn. But if you or your spouse is eligible, your tax deduction for making an IRA contribution may be reduced or completely eliminated depending on your adjusted gross income (AGI).

If you aren't eligible to make a deductible contribution (or a Roth IRA contribution), you may wish to make a nondeductible one you'll still enjoy the benefit of tax-deferred growth. And, when you withdraw the funds after age 591/2, only the earnings will be taxed. You can withdraw your nondeductible contribution without tax.

Roth IRA. You are able to contribute the same amount to a Roth IRA as you are able to contribute to a traditional IRA. The real difference between the two is their eligibility rules, such as the lack of an age limit with respect to contributions. This disregard for the age limit is only applicable if you meet the earned income requirement.

The total amount of your annual contribution to IRAs can never be larger than the defined limit. That being said, if you are eligible you can contribute all of your income to a traditional or all of your income to a Roth IRA. You are even allowed to split your contribution between the two different IRA?s.

The Roth IRA also differs from a traditional IRA in that you won't be able to claim a deduction for your contributions. But all Roth IRA earnings can be withdrawn tax free after age 591/2, provided you've had the account for at least five years. (You can withdraw amounts up to your total contributions tax free at any time.)

Traditional IRAs also have required minimum distribution rules that must be followed, Roth IRAs do not have such restrictions.

If a Roth IRA sounds like a better place to park your retirement funds but you already have a traditional IRA, you may be able to elect to convert some or all of it to a Roth IRA. In so doing, you'll be creating taxable income, but you'll also be getting the benefit of future tax-free withdrawals.

Simplified Employee Pension (SEP) IRA. A SEP IRA provides self-employed individuals a way to make more significant retirement contributions than would be available to them through a traditional or Roth IRA. Funds are treated, for tax purposes, the same as IRA funds; you may claim a deduction for your contributions, and distributions will be taxed. But the contribution limits can be much higher.