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Investment Vehicles and Taxation

Okay, so you know what you want to invest in (stocks, etc). You know you want to use mutual funds to manage those investments. Now you get to decide how to hold those mutual funds. Enter the wonderful world of the IRA, 401(k), 403(b), and a small horde of other investment vehicles. Think of these all as various types of "baskets" to put your investment eggs in. Their job is to protect your investments from taxes, which would otherwise be yet another drag on your investment returns. Think about this: You earn a salary, right? So you pay taxes. Every year. If you don't use some sort of tax-sheltered investment vehicle, you have to pay taxes on your investment earnings every year too. That's not a good thing, since over the long run, that can cut your nest egg in half, or worse. So, what to do? Use some of these available investment tax-sheltering opportunities.

Probably the easiest to start with is the Individual Retirement Arrangement, or IRA (no, the "A" doesn't stand for "Account"). There are two flavors of IRAs: Traditional, and Roth. You will likely want the Roth if you're more than 10 years from retirement. Here's why: With a traditional IRA, you put money into the basket before paying taxes on it. So whatever you put into the IRA doesn't get taxed by the IRS as income for the year. That's kind of nice, since it enables you to put in more than you would otherwise be able to. The money grows tax-deferred (you don't need to pay taxes on the principal or earnings every year) until you retire (unless you take it out before then, paying a hefty fine for the privilege). When you retire, the tax-man gets his cut, as everything you withdraw is taxed at regular income tax rates. That will end up being a very large sum. While traditional IRAs are frequently justified by saying something silly like "but you'll be a in a lower tax bracket when you retire", who among us really hopes that we'll be so much poorer when we retire that we'll be in a lower tax bracket? Personally, I'd like to have more income when I retire than I do now, not less. So the Roth makes more sense. If you know you'll have much less income when you retire, then a traditional IRA is worth considering if you're close to retirement.

The Roth IRA (actually pretty new to the investing world, they were established in 1998) works differently. You put in after-tax money (with no tax break the year it's earned and contributed). That money then grows, and earns more within the IRA. When you finally do retire, and start withdrawing the money for retirement, you pay no taxes on the withdrawals. None. Not on the principal you contributed (since you already paid taxes on that money, remember), and not on the money you've earned over the years, which often dwarfs what you actually contributed. Imagine never having to pay taxes when you retire. If you use a Roth IRA (or its big brother, the Roth 401(k)), that could be a reality for you. Another benefit of the Roth IRA is that you can withdraw your contributions (though not the additional earnings) at any time, without penalty. You've already paid taxes on them, so why not? So the Roth IRA can serve as a backup "emergency fund" should you ever get in a financial crisis and need the funds for something else.

Investing within an IRA is really simple. There are a few rules: you have to have earned at least as much income as you contribute for a given year, and you can't have an outrageously high income. The process usually goes like this: You pick your mutual fund company, and the funds you want. When signing up for the accounts, you'll choose to "open an IRA" with the group. Basically, this means another form or two to fill out online, which may take five more minutes. That's really about all the trouble involved in opening an IRA. Perhaps the biggest "catch" to the IRA is that you can't save all the money you want to in the account. You're limited to a certain sum: currently (2008) $4000 a year, $6000 if you're 50 or older. So, while it's a nice thing to have, it probably shouldn't be the only investment basket you ever have.

The 401(k) or 403(b) (which works the same way) is another investment vehicle to help you get safely to retirement. The contribution limits are higher: currently (2008) $15,500 for anyone under 50, which should be plenty for most people. They're offered through your workplace (the 403(b) is for people working with nonprofit agencies), and you usually have to go to your Human Resources person to get the info, unless you still have the packet they gave you when you joined the company, which most people (being ignorant of its importance) promptly toss aside. Once again, there are two flavors: the regular 401(k), and the Roth 401(k). These work just like the two types of IRAs above. For most people, I feel that the Roth 401(k) makes more sense (see reasons for IRAs, above). They're not yet widely available, however (The Roth 401k was just introduced in 2006), and if you're stuck with just the plain old 401k, use it anyway. Many employers have a really nice policy of matching the funds you contribute to your 401k, which is basically like getting an immediate and guaranteed return on your investment. If your employer offers this, definitely take advantage of this while it lasts, to the extent that you can. If you don't get a company match, I would probably fund a Roth IRA before a 401(k), since you'll have a wider choice of investments available (with a company plan, you're usually limited to what they offer).

There are a few other types of tax-sheltering investment vehicles, including SEP IRAs, KEOGHs, SIMPLE IRAs, and a few others, primarily for self-employed individuals or those working with small companies. Look into these if that's the case for you. They work pretty much like traditional IRAs, but with higher contribution limits.

While we're on the subject, there's also something called a Coverdell Education Savings Account (or ESA), formerly called the Education IRA. This and the 529 plan are ways to tax-shelter money intended for your kids' college expenses (the Coverdell can be used for primary and secondary school expenses as well). What I'll say about these here is that most people shouldn't be putting money aside for their children's college expenses until after they've fully funded their retirement accounts. Far too many parents end up crippling their own retirement for the sake of their kids, who really don't need the money that much anyway (more money saved for the kids translates into less money available in the form of grants, etc). Also, if you're using a Roth IRA or 401(k), you can take out your contributions at any time, remember? If you're going to pay for their college experience, it's better to use your retirement funds (which are not included in the government's financial need calculations) than a specific fund set aside for them (which are). Besides, you kids won't be economically crippled if they go to a public university, which is a far better (and more affordable) option than an institution with overpriced ivy-covered buildings anyway.

Take the time to plan for your child's future.