IRAs Versus 401(k)s--Which Is Better? 89 What Is an IRA? An IRA, or an individual retirement arrangement or account, is a protective shell. You will recall that any money deposited into a protective shell continues to grow on a tax-deferred basis until you withdraw it. You can establish an IRA account at a bank, brokerage, mutual fund, or insurance company. And the IRS says that you can contribute up to $2,000 per year to this account ($3,000 in 2002). The beauty of IRAs is that your after-tax contributions to an IRA can be turned into pre- tax contributions (you get a tax deduction) if you meet certain income requirements. Any money that you contribute and invest within the IRA is free from taxes until you withdraw it. Think of an IRA as a mini-401(k). An IRA does many of the same things as a 401(k), but it is not as flexible. Before we can show you how to compare 401(k)s and IRAs, you will need a refresher on the many new types and features brought on by recent tax law changes, including the differences between tax credits and tax deductions. Terms to Know A tax credit reduces the income tax that you pay. A tax deduction reduces your taxable income before income taxes are calculated. A tax credit reduces the income tax that you pay, dollar for dollar. If you owe the IRS $5,500 in income taxes, a tax credit of $1,500 would reduce your tax liability to $4,000 ($5,500 ­ $1,500). A tax deduction reduces your taxable income before income taxes are calculated. So, a $1,500 tax deduction would reduce your taxable annual salary of $35,000 to $33,500. A $500 deduction is worth only about $140 of tax savings. A tax credit of $500 is worth $500 in tax savings. Are There Different Types of IRAs? This used to be an easy question to answer, but thanks to the Taxpayer Relief Act of 1997, that is no longer the case. Let's start from the top. There are some general rules that apply to all IRAs: · The most that you can contribute to your IRA account(s) in any tax year is set by Congress. Thanks to EGTRRA, the 13-year-old $2,000 limit will increase according to this table. Table 9-1. New IRA Limits Allowed by EGTRRA 2001 2001 Maximum contribution Age 50 + catch-up con- tributions $2,000 Not available 2002­2004 $3,000 $500 2005­2007 $4,000 2005­$500 2006+­$1,000 2008 $5,000 $1,000 Inflation Increase 2009­$500 No adjustment · Earnings and gains on all investments within an IRA are tax-deferred until withdrawn. · In most cases, a 10 percent penalty will apply if you dip into your account before age 59½.