Planning For Retirement - Traditional IRA's

It can be difficult to wade through the jungle of retirement planning options available to most people. TV commercials warn that if you choose the wrong type of plan or the wrong investments, you will end up penniless. For those who have 401(k) plans set up by their employers, this is usually the best and most flexible option. But the majority of workers do not have access to a 401(k) plan and must set up their own individual plan.

Let's take a look at a popular alternative- the traditional Individual Retirement Account or IRA. An IRA allows you to grow your retirement funds without tax consequences until retirement. Contributions to a traditional IRA are tax-deductible from current income and will only be taxed on retirement.

For example, let's say you earn $60,000 a year. The maximum you can contribute, based on IRS rules, to the plan is $4,000 ($5,000 if you are age 50 or over). You can deduct that $4,000 on your tax return meaning you don't pay tax on that portion of your income. The funds are invested in your plan based on the investments offered and your choices. You can begin withdrawing without penalty from your plan when you turn 59 ½. If you withdraw that $4,000 plus the investment income it has made over the years, you will be taxed in the year of withdrawal on both the principal and the income.

The tax effect of investing in a traditional IRA depends on your individual tax situation. If you are in the same tax bracket at retirement as you are when you make the contributions, the tax effect is simply that taxes are deferred. You pay them later instead of now. Later is always better than now because of the time value of money. Having more money in your pocket today allows you to invest that money rather than shell it out to Uncle Sam.

If, however, you are in a lower tax bracket at retirement than you are in now, it represents an exemption of a portion of the tax. In other words, if you would have to pay $1,200 in taxes today on the $4,000 contribution, but would only have to pay $900 at retirement because your income is lower, then that means that you have permanently saved $300 in taxes.

Understanding how a traditional IRA fits into your overall retirement strategy can maximize your retirement income and save taxes over the long run.

Author and entrepreneur Bernz Jayma P. is the owner of a financial blog dedicated to helping people expand their knowledge on personal finance. You may visit his blog at http://www.Invesmint.com.