401(K), IRA and Roth IRA -- I

I guess many people, just like me, already heard of them, knowing that they are some kind of retirement accounts, but not sure exactly what the differences among and the advantages and disadvantages of them. As I am going to have them of my own and even audit them as part of my job, I did some research and here is the brief summary.

1. 401(k)

It's an employee benefit provided by the employer. Some details may differ from company to company, depending on the plan agreement. But most of the plans have to follow the law. For example, once an employee is elibible to participate the plan, he/she can elect to contribute certain amount of money into the plan. The maximum amount that an employee can contribute is $14,000 in 2005 and $15,000 in 2006. The annual dollar limit will increase by $500 annually beginning in 2007 and thereafter. An employee gets to choose the investment portfolio of this money. Then the employer has to take the designated dollar amount from employee's paycheck to put it into the plan. Usually, an employer will match up certain percentage of the amount that the employee contributes. For instance, if I decide to put $10,000 into the plan, then my firm will match up 25% of what I put in, that is, $2,500, a year. If I fully vested in that year, I will have $12,500 in my 401(k) as principal.

The advantage of this plan is not only that you can have your employer to pay a portion of your retirement plan, but also all these money are basically tax-free. Take my example, the $10,000 that I put in the plan will no longer be taxable in that year, nor the $2,500 that the firm matches up. Besides, you can choose how you are going to invest these money; well, of course only among the mutual funds that your plan provides.

Maybe I should not use the term "tax-free" before, because it's not. "Deferred" might be a better word because the money is taxable when distribution. Yep, when you reach 59.5 years old and want to take your money back, it is taxable. You can only hope that by the time you retire, you don't have that much income and are subject to lower tax bracket. Oh, and also, you must take the required minimum distribution once you reach 70.5 or your retirement date, whichever is later. It's not like you can put the money there forever; come on, what's the purpose for that?

Since this plan is to encourage employees to save for their retirement, it doesn't want any amount to be taken out before retirement. So basically you CANNOT take out any money before you reach 59.5 except for "Hardship Withdrawals". It means that you can take the money out before 59.5 from the plan for some "Hardship" reasons like, buying your principal residence, paying tuition and paying medical care expense. However, this should be your last financial resort because when you take the money out, this money is subject to 10% penalty and you have to pay the tax. Furthermore, you cannot put any money back in the plan for 6 months. So once you decide to participate the plan, you must be prepared to leave these money alone for a while.

-- To be continued.