401(k), Traditional IRA, and Roth IRA

Came upon this brief description of the three tax-advantaged retirement accounts on Morningstar.com and thought it would be a good idea to paste that info here. I would have just linked to their web site, but it's from their pop-up window that doesn't show an address. Anywho, here it is:

401(k)s
401(k) plans, so named after a section of the Internal Revenue Code, are set up by employers as a retirement-savings vehicle. The primary advantage of a 401(k) is tax deferral. First, employees can contribute a percentage of their income from each paycheck to their own 401(k) accounts on a pretax basis. This means the amount you contribute to your 401(k) is exempt from current federal income tax. For example, if you are in the 25% income tax bracket, a $100 contribution will reduce your current tax burden by $25. Second, dividends and capital gains earned inside a 401(k) are not subject to current taxation. In short, 401(k) plans allow you to defer taxation on dividends, capital gains, and a portion of your wages until you begin withdrawing from the plan, presumably during retirement, when you may be in a lower tax bracket. (All withdrawals are taxed at ordinary income rates.)

The amount you can contribute to your 401(k) plan is limited to $14,000 in 2005 and $15,000 in 2006. Thereafter, the annual contribution limit can be adjusted in $500 increments to account for inflation. You also must begin mandatory withdrawals from your 401(k) when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed as ordinary income, and you may be subject to an additional 10% penalty.

Traditional IRAs
Individual retirement accounts are another vehicle for tax deferral. When you contribute to a traditional IRA, the IRS allows you to take an income tax deduction up to the amount of the contribution, subject to income limitations. In addition, dividends and capital gains earned inside a traditional IRA are not subject to tax until withdrawal.

However, there are some important limitations to remember. First, you must be age 70 1/2 or under with earned income to contribute to a traditional IRA. Second, the annual contribution limit is $4,000 from 2005 to 2007. The limit rises to $5,000 in 2008, and thereafter can be adjusted in $500 increments to account for inflation. If you are age 50 or older, you can make additional "catch-up" contributions of $500 in 2005 and $1,000 from 2006 onward. Finally, like 401(k) plans, you must begin mandatory withdrawals when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed and may be subject to an additional 10% penalty.

Roth IRAs
These are typically the best retirement account option for many taxpayers. As with traditional IRAs, interest income, dividends, and capital gains accumulate tax-free. However, the main feature of Roth IRAs is that they are funded with aftertax dollars (contributions are not tax deductible). The upside of this is that qualified distributions from a Roth IRA are exempt from federal taxation.

The Roth IRA has the same annual contribution limits and "catch-up" provisions as a traditional IRA, but you must meet certain income requirements to contribute to a Roth IRA. Generally, single filers with income up to $95,000 and joint filers with income up to $150,000 are eligible to make the full annual contribution to a Roth IRA. Contributions to a Roth IRA can be withdrawn at any time without paying taxes or penalties, but withdrawal of earnings may be subject to income taxation and a 10% early withdrawal penalty if made before you turn 59 1/2.

In addition, the distribution must also be made after a five-tax-year period from the time a conversion or contribution is first made into any Roth IRA. So, if you open your first Roth IRA and make your first contribution on April 15, 2005, for the 2004 tax year, your five-year period starts on Jan. 1, 2004. Assuming you meet the other requirements, distributions made in this case after Dec. 31, 2008, from any Roth IRA will receive tax-free treatment.