What is an IRA?

Everyone keeps telling you that you need to save for your retirement, but your company does not have a 401(k).  What are you supposed to do?  You can contribute to an Individual Retirement Account (IRA)!

 

The advice that everyone is giving you is right, you need to make sure you save for your own retirement.  One estimate projected that the Social Security trust fund will be exhausted by 2037 if not sooner.  I discussed this and provided advice for your retirement savings plan in Plan for Your Retirement: No One Else Will.

 

If your employer does not provide a company 401(k) plan, you will want to talk to your financial advisor about establishing an IRA.  But what is an IRA?

There are 2 basic types of IRAs:

 

1) Traditional IRA

 

Qualified contributions to a Traditional IRA help to reduce your taxes because they are tax-deductible.  Contributions to a Traditional IRA are one the few ways in which you can actually reduce your tax bill after the year ends.  The governments allows you to make a contribution up until April 15th of the following year, and to take the deduction in the preceding year.

 

The amount you are allowed to contribute to a Traditional IRA changes frequently as it is adjusted for inflation, but in 2013 you are allowed to make a contribution up to $5,500, or $6,500 if you are age 50 or over.

 

Once invested into a Traditional IRA, all of the funds grow without being taxed.  You will not be taxed until you withdraw the funds! 

 

There are a few basic requirements in order to make a contribution to a Traditional IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must be under the age of 70.5
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA)

 

Be careful though.  The ability to make a tax-deductible contribution phases out based upon whether or not your employer provides a company retirement plan, your tax filing status, and your income level. 

 

2) Roth IRA

 

The principal difference between Traditional IRAs and Roth IRAs are that with Traditional IRAs the contributions are tax-free while with Roth IRAs the distributions are tax-free.

 

In 2013, you are allowed to make a contribution up to $5,500 or $6,500 if you are age 50 or over.  However, the contribution limitation changes based upon your tax filing status and your income level.

 

Once invested into a Roth IRA, all the funds grow tax-free.  Furthermore, all of the distributions are tax-free provided that you are over the age of 59 1/2 and have had the Roth IRA account for at least 5 years.

 

Again, there are a few basic requirements in order to make a contribution to a Roth IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA).

 

You will notice that unlike with Traditional IRAs, there is no age restriction on being able to contribute to a Roth IRA.

 

Of course these are only the 2 most basic types of IRAs.  You may want to discuss non-deductible IRAs, SEP IRAs, and SIMPLE IRAs with a financial advisor to determine what type of IRA makes the most sense for your situation.  If you need a referral to a great financial advisor, please do not hesitate to ask me.

 

If you have any tax questions that I can answer, please send me an e-mail.

 

Please feel free to leave your feedback below.

 

Plan for Your Retirement: No One Else Will

The Social Security trust fund will be exhausted by 2037.  This is according to one estimate provided by the Social Security Administration.

This means that it is up to you to provide for your retirement. But don't worry, you can make sure that you have a comfortable retirement if you follow two pieces of advice:

1) Start saving for your retirement early.  Start now.  I know, you have a lot of bills to pay and it will be decades until you retire.  You feel like you can start saving when you are more financially secure, and will just make up for starting later by saving more in the future.  This could work, but it comes at a cost.

For example, take Bill and his friend Bob.  Both are young men with a lot of bills, but Bill's family taught him to start saving for his retirement as soon as he could.  Both got hired to full-time jobs when they were 24 years old.  Bill looked at his expenses, and realized he could contribute $2,000 a year to his retirement at the end of every year.  He invested conservatively, and earned a steady 5% return without taxes every year.  At the age of 65, he had just under $270,000 saved.

Bob, on the other hand, did not set aside any money in his 20s or 30s.  It took Bob 20 years to feel financially secure enough to start contributing to his retirement account.  Bob, now 44 years old, wanted to catch up with Bill and decided to put  $7,000 a year into his retirement account at the end of every year.  Bob invested the same as Bill, and earned the same steady 5% return without taxes every year.  At the age of 65, he had just over $260,000 saved.

As you can see, in order to have between $260,000 and $270,000 in their retirement accounts, Bill only had to contribute $82,000 while Bob had to contribute $147,000 ($65,000 more).  This is all because Bill started saving at an early age.

That is the power of compounding investment returns.

2) Invest through a qualified retirement plan.  The IRS gives special tax treatment to certain types of retirement accounts including, but not limited to:

• 401(k)
• 403(b)
• Traditional IRA
• Roth IRA

There are different features and tax incentives attached to each of these types of retirement accounts, but they share one very important feature.  All the earnings grow tax-free.  Bob and Bill both had their money invested in a qualified retirement account, so all of the earnings grew tax-free.  If they decided to put their retirement savings in a normal investment account, they each would have had far less in their retirement accounts because they would have a significant amount taken out each year in taxes.

It is very rare for the government to allow you to invest your money without taxing it for decades, if ever.

These types of retirement accounts have another significant tax incentive.

Contributions to 401(k)s and 403(b)s reduce the amount of taxable wages you report on your tax return.  For example, if you earned $100,000 in a year, and you contributed $5,000 to your 401(k), your W-2 would only show $95,000 of gross wages.

Contributions to a Traditional IRA are deductible for the year of the contribution.  Thus, if you earned $100,000 during the year and contributed $5,000 to your Traditional IRA, you would take a deduction on your tax return for $5,000, leaving you with gross income of $95,000.

Assuming you are in a 25% federal tax bracket, you would save $1,250 in federal taxes for making a $5,000 contribution to your own retirement.

Distributions from a Roth IRA are tax-free.  This is delayed gratification, but if you expect to be in a higher income tax bracket when you retire or you think that tax rates will go up, you can choose to put your money into a Roth IRA and let it grow tax-free and then eventually take it out of your retirement account tax-free.

Please note that this is only a very brief overview of retirement plans.  I plan to discuss different aspects of retirement plans and the benefits to employers to sponsoring a 401(k) or 403(b) plan in future blog posts.

I strongly encourage you to talk to your financial advisor about setting up a retirement plan if you do not have one already.  If you need a referral to a financial advisor, I know a great financial advisor who would be happy to answer any of your questions.

I would love to get your feedback through comments below.  If you have a question that you would like to discuss with me privately, please do not hesitate to send me an e-mail.