An Overview on Individual Retirement Accounts (IRAs)
Retirement is one of the only words known to man that has the ability to produce such a wide-range of reactions. Some people will get glassy-eyed as if they can literally see into their future while a smile dances at the corners of their mouth. On the other hand, others will immediately begin to squirm because they know how unprepared they are for their looming retirement. In this section we will discuss the Individual Retirement Account, more commonly known as an IRA. We will first learn the definition of what an IRA is, the historical and current day limits on IRAs, and a few myths and facts. Finally, we will compare the Traditional IRA to the newer Roth IRA.
Traditional IRA, definition: A Traditional IRA is a tax deferred retirement vehicle. Contributions to a Traditional IRA plan may be tax deductible depending on the taxpayer’s income, tax filing status and other factors. Contributions to Traditional IRAs are made on a pre-tax basis, meaning the money is invested before it is taxed.
Roth IRA, definition: A Roth IRA is a tax-exempt retirement vehicle. Contributions to Roth IRAs are not tax deductible when they are made; however, qualified distributions made during retirement years are tax free.
IRA Facts
Individual investors have a variety of ways to save and better prepare for the future. When it comes to funding your retirement, similar to other types of investing, there are numerous factors to consider. Choosing an investment plan depends on the length of the investment (time horizon), your personal or family budget, and your expectations of performance versus the risk involved (Risk vs. Reward).
An individual retirement account (IRA) is a personal retirement savings plan with tax benefits, and also, very specific tax consequences if not followed properly. An IRA is one of the most powerful retirement savings tools available to the individual consumer. Even if your employer offers a 401(k) or other type of qualified retirement plan, you should strongly consider investing in an IRA.
Retirement savings can be thought of as a “three-legged stool.” Each leg represents a portion of your retirement benefits and each is considered to be only one part of a complete approach to retirement planning. The three legs are thought of as Social Security benefits, pension/401k, and personal savings, such as the IRA. Over the past 20 years the personal savings leg has been required to get much larger due to the decrease of pension plans in the American workforce.
Traditional IRA
HISTORY: The Employee Retirement Income
Security Act (ERISA) of 1974 created what is now known as the traditional individual retirement account (IRA). The IRA was established for people without employer-sponsored pension plans in order to save for retirement. Contributions would not be taxed (which means they were fully tax-deferred) until the funds were withdrawn, and a 10% penalty would be levied for withdrawing funds before age 59 and a half.
Initially, IRAs were strictly for people who were not covered by a pension plan. Workers that were covered by pensions weren’t eligible to participate in IRAs, and many felt that restriction was unfair. The Carter Administration also thought the restriction was faulty, and moved to rectify it. To increase individual savings and investments, a tax law was passed in 1981 which made IRAs available to all workers. These rules were put into place to encourage lower-income workers to invest and save more, but in the end it did not work out as planned.
Eventually, it was discovered that high-income workers (typically with pension coverage) were the ones taking advantage of IRAs. Higher-income workers obviously liked the advantages of the newly available tax savings. Congress again responded with the Tax Reform Act of 1986, which placed tight restrictions on IRAs implemented major changes. From this point on, only employees without pension coverage were allowed to have fully tax-deferred deductions or they had to earn less than a certain income limit ($35,000 – individuals; $50,000 - married couples). These new restrictions were met with displeasure and eventually lead to the creation of the Roth IRA.
PRESENT DAY: Traditional IRAs are available to any investor under the age of 70 and a half who has taxable income. Effective for 2013 tax year, annual contributions are limited to $5,500. An additional $1,000 "catch-up contribution" can be made if you are over age 50. Money cannot be withdrawn prior to 59 and a half without a penalty, unless certain exceptions are met. Also, owners are required to begin making minimum withdrawals at age 701/2 according to government regulations. Remember, your income must be at least equal to the amount you are investing in the IRA. Contributions may be tax deductible. If you (or your spouse) are not covered by a 401(k) plan through your work, then you should be able to make a tax deductible contribution. If one of you is covered by a 401(k) plan, then your ability to deduct your contribution will depend on the amount of money you made over the year, which is known as your modified adjusted gross income (MAGI). For more in-depth information regarding Traditional IRAs, please refer to the section titled “Traditional IRA vs. Roth IRA.”
Roth IRA
HISTORY: The Roth IRA was born on January 1, 1998 as part of The Taxpayer Relief Act enacted in 1997, and is named after Senator William V. Roth of Delaware. The Roth IRA removed some of the restrictions tied to the traditional IRA. For instance, employees were no longer bound by the same income levels imposed by the traditional IRA. Contributions to the Roth IRA were not tax deductible as they were with the traditional IRA, however, there would be no taxes upon withdrawal of the funds.
Roth IRAs could be withdrawn without penalties upon reaching age 59 and a half. Also, as opposed to the traditional IRA, Roth IRAs were allowed to be invested for an indefinite amount of time. Funds in the Roth IRA could be stretched to future generations unlike the traditional IRA.
In 2001, Congress decided to change the laws concerning IRAs. At that time, both types of IRAs were allowed a maximum contribution of only $2,000. The Economic Growth and Tax Relief Reconciliation Act raised these limits. The maximum contribution amounts were raised almost bi-annually from 2002 through 2012 as follows: $3,000 in 2002-2004; $4,000 in 2005-2007; and $5,000 in 2008 through 2012. Effective for the 2013 tax year, the annual contribution limit is $5,500. An additional $1,000 "catch-up contribution" can be made if you are over age 50. Limits may continue to be raised in accordance with inflation rates.
CURRENT: Roth IRAs are extremely advantageous since contributions and earnings portions are potentially tax-free upon withdrawal. The requirements for obtaining money from your Roth IRA tax-free are a five-year holding period, age 59 and a half at withdrawal, disability, up to $10,000 for a first-time home purchase or a withdrawal made by your estate upon your death. The ability to withdraw funds without paying taxes or penalties is the key strength of the Roth IRA. Unfortunately, not all investors are eligible to contribute to Roth IRAs since eligibility depends on your modified adjusted gross income (MAGI) and tax filing status.
Our opinion is that you NEED a Roth IRA, period. The reason you NEED it is because it’s the best government-sanctioned, get-rich-slow, wealth building, tax conscious investment you can own. Too bad there is a limit as to how much can be invested annually. For more in-depth information regarding Roth IRAs, please refer to the section titled “Traditional IRA vs. Roth IRA.”
4 Myths about IRAs
Myth: My money is untouchable until I reach 591/2.
Truth: This is somewhat true, but there are exceptions to this rule. For example, you can withdraw the contributions at any time, tax-free and penalty-free; the earnings made from the contributions are what can't be touched without paying taxes and a 10% penalty. Other exceptions include: Up to $10,000 for a first-time home purchase, certain qualified higher-education expenses, disability, death, a series of “substantially equal periodic payments (called a 72t), back taxes, and unreimbursed medical expenses that exceed 7.5% of MAGI.
Myth: Other than the company match, there is no difference between an IRA and a 401(k).
Truth: The most basic as well as most important difference between these two is that the IRA offers you more investment choices and, you’ll likely pay a lot less in fees. With most 401(k) plans, participants are limited to a handful of mutual funds, typically between 12-20 choices. The other major downside is that the expense ratios (cost to own and maintain the fund) in a 401(k) are often higher than they would be if purchased in an individual IRA.
Myth: Annual fees must be taken out of IRA assets.
Truth: The bank or brokerage that manages your IRA may automatically withdraw annual fees out of your assets, but you can choose to pay separately with a check or cash (if accepted). Paying separately will leave more assets inside your account, which will increase the amount of money you have for retirement. Plus, these fees are considered by accountants to be investment expenses that are deductible to the extent that they, along with all your other miscellaneous deductions, exceed 2% of your adjusted gross income.
Myth: You can't use an IRA to buy a house.
Truth: $10,000 of the money in your IRA can be used for a first-time home purchase. Just because it is possible doesn’t mean it’s easy, it is complicated, time-consuming, and harmful to retirement dollars.
Regardless of whether you participate in a traditional IRA, Roth IRA, 401(k), or all three; make sure you contribute regularly to your future well-being. The final and most important truth...the more you save now, the more comfortable you will be during retirement.
Which IRA is best for you?
Let’s assume that you are eligible for both a traditional IRA and a Roth IRA. Which should you choose? The choice is difficult and depends on many factors which should be discussed with a financial advisor. Age, time horizon, investment objectives, and tax status should all be a major part of the discussion.
- Choose the Roth IRA if you don’t require the tax break immediately. It's much more flexible because it allows you to withdraw contributions at any time, tax-free and penalty-free. Also, there are no required minimum distributions at age 70 and a half.
- Choose the traditional IRA if you must have the tax deduction right away, or if you anticipate paying taxes at a significantly lower rate during retirement.
On the other hand, if you don’t qualify for tax deductible contributions then the Roth IRA is a great investment tool. We should also point out that there is such a thing as a non-deductible traditional IRA, but you won't realize any tax benefits when compared to those available through Roth or through a tax deductible traditional IRAs.
When you have solved the "Traditional IRA vs. Roth IRA" dilemma, there is just one thing left to do… open an account.
A little more information…
Consumers can open an IRA at the bank, at a brokerage firm, or directly from the mutual fund company. Available investments include: Certificates of deposit, stocks, bonds, and mutual funds. Some restrictions apply on IRA investments; these are collectibles (such as stamps or art), life insurance contracts, and most investment property.
