Our friends in the federal government want us to save for retirement. Otherwise, the government would have to pay out even more than it now does under Social Security and Medicare. The primary motivational mechanisms created by our elected officials are tax breaks. By investing in the various retirement plans for which you qualify, you will enjoy at least one and possibly two of these tax-saving benefits:
- Tax deferral. All retirement savings plans share one thing in common: Investments inside these plans are not subject to taxes on the income you earn on their investments until you begin making withdrawals.
- Tax deduction. Many retirement savings plans also allow you to take a tax deduction for money you put into the plan or allow you to reduce your salary by the amount of your contribution, which is the same as a tax deduction.
- Tax-free withdrawal. In the case of the Roth IRA, the money you withdraw when you're retired is generally tax-free.
Which retirement plans are best? There's a lot of confusion about which retirement plans are preferable. Since most workers have at least a couple of choices, some guidance is in order. Almost all retirement plans are worthwhile, but some are better than others. Here's a hierarchy of retirement plans.
First, any plan where the employer matches your contribution is too good to pass up. After all, it's free money.
Second is any pre-tax plan like a 401(k) plan or 403(b) plan (tax-sheltered annuity), a tax-deductible plan like a self-employed plan, or a tax deductible IRA, if you qualify. All reduce your current taxes.
Finally, a nondeductible plan will still grow in the future free of taxes. Of the available nondeductible plans, a Roth IRA is best it you qualify. In fact, a Roth IRA is so advantageous that it will probably be preferable to a tax deductible IRA if you don't really need the deduction.