Retirement planning – it’s unpleasant to think about, and the IRS doesn’t make it any easier, what with so many types of plans out there.  But 401k plans and IRAs are both effective tools to save tax-deferred for retirement; the trick is to know the rules for each.

IRAs.  Opening an IRA is easy, you have the freedom to invest the contributions in virtually anything you want, and change your mind at any time.  You can choose either a Traditional IRA, or a Roth IRA.  Either one lets you contribute up to $5,000 per year ($6,000 if you’re nearing retirement age).

Traditional IRA. For a Traditional IRA, contributions are deductible on your income tax return.  If you are also in a qualified plan through your employer, such as a 401k, 403b, or 457, the deduction starts to phase out for income higher than $56,000 ($89,000 for married filing jointly).  Your contributions to a Traditional IRA grow tax-free until you start drawing the money out, at which point they are taxed as ordinary income.

As for drawing the money out, you can’t start taking distributions until you’re age 59 1/2; if you take a distribution sooner than that, you’ll be subject to a 10% tax penalty, although you may escape that penalty if your withdrawal is for a “qualified” event, such as a first-time home purchase or higher education expenses.

Roth IRA. There’s no tax deduction for a Roth IRA contribution, but as a result, your “qualified” distributions are tax-free.  To be qualified, you must be age 59 ½ and your IRA account must be open at least five years; if not, the distribution might still be tax-free if it’s for a “qualified” purpose, such as the purchase of a first home or disability.  Otherwise, early distributions suffer a 10% penalty.

401k Plans.  There’s no Form 1040 deduction for a 401k; instead, because your contributions are deducted from your taxable income, the income figure on your W-2 is lower.  Like a Traditional IRA, contributions to a 401k grow tax-free until you take them out, when they are taxed as income.

But you can defer much more money – $16,500 in 2010 – with a 401k.  And if your employer offers matching contributions, take advantage of it.

Another bonus of the 401k is the ability to borrow from it – you can’t borrow from an IRA.  You can also take penalty-free distributions before age 59 ½ if it’s a hardship withdrawal, but be warned:  the IRS has strict rules about what constitutes a “hardship.”

The main drawbacks of the 401k plan are that your employer may offer limited investment choices, and your contributions may not vest for several years.  So, become familiar with your plan’s limits,  and take a lesson from the Enron employees who lost out when their employer went bust – don’t invest your 401k too heavily in your own company’s stock.

Both the IRA and 401k are sound retirement planning choices that will help you build a tax-deferred nest egg.  If you can invest in both, start with the 401k, then open an IRA once you’ve maxed out your employer’s match.  If you can afford to, max them both out.  In the end, your retirement will depend on how well you save for it now.

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