Warning: This is a super-long post. But I wanted to try to explain the wonders individual retirement accounts for the people who don’t currently save for their golden years. If your employer doesn’t sponsor a 401(k) or other retirement plan, open and fund an individual retirement account before April 15. Here are some FAQs for the uninitiated:
Who can contribute? According to the IRS, anyone younger than age 70-1/2 who has earned income during the year can put in up to $5,000 in an individual retirement account ($6,000 if you’re over age 50. But you can’t put in more than you actually earned. So if you made $2,000 working part-time, that’s the most you can contribute. The exception is the spousal IRA, for married people who don’t work, and file their tax return jointly with a spouse; they can contribute the same as a working person with an IRA. (The deadline for a 2010 contribution is before tax day, April 15, 2011.)
Where do I set up my IRA? You can set up an IRA with a variety of organizations—banks, mutual fund companies, life insurance firms, stockbrokers. Consider a mutual fund company that has a reputation for low-cost investments, such as:
Vanguard Group, www.vanguard.com (877) 662-7447
Fidelity Investments, www.fidelity.com (800) 343-3548
Charles Schwab Corp., www.schwab.com (866) 855-9102
T. Rowe Price Group, www.troweprice.com (800) 225-5132
Keep in mind that many fund companies require a minimum IRA investment of $3,000. (See this Wall Street Journal piece on that topic.) When you set up your account, also set up the “automatic transfer” feature; it allows you to electronically contribute a regular amount every month directly from your checking account.
What should I invest my IRA contribution in? If you are not an avid investor, choose a “life-cycle” “target- strategy” or “age-based” mutual fund, based on the year you plan to retire. It invests your money in a mix of stocks and bonds.
What’s the difference between a traditional IRA and a Roth IRA? Money in a traditional IRA grows tax-deferred. That means you don’t pay interest on your investments, or the money you earn on them, until you withdraw the cash in retirement. Contributing to a traditional IRA also reduces your taxable income. Uncle Sam wants to encourage people to save for retirement. For that reason, the money you set aside in a traditional IRA is deducted from the income you report for tax purposes. Let’s say you earn $31,000. You put $3,000 away during the year in your IRA. You subtract that from your gross income ($31,000 – $3,000 = $28,000). As far as Uncle Sam is concerned, you only earned $28,000. This shrinks the amount you have to pay to the government on April 15.
Drawbacks: IRA money is supposed to be for retirement, so if you withdraw your savings before age 59-1/2, you’ll pay a 10 percent penalty and income taxes. However, there are some exceptions to that rule. For instance, you can tap $10,000 of the money penalty-free (one time only) to buy or build your first home, pay for qualified higher education expenses; or pay for big medical bills that aren’t covered by insurance. You can also tap the money if you become disabled. You won’t pay the 10 percent penalty in those cases, but you will have to pay some tax on the money in the year you withdraw it because you didn’t pay any tax on it when you put it in the account.
Also, you have to begin taking something called “required minimum distributions” by age 70-1/2 or Uncle Sam will slap a penalty on you. So it’s not easy to pass an IRA on to your heirs.
When you take the money out of the traditional IRA, you pay ordinary income tax on the money. Why does Uncle Sam wait until you’re retired to tax you? Because, theoretically, you’ll probably be in a lower income tax bracket. As you know, income taxes rise with earnings—the more you make, the more taxes you pay, as a percentage of income. For instance, a single person making $34,000 is in the 15 percent tax bracket; someone earning $85,000 is in the 28 percent tax bracket.
Here’s the whole traditional IRA concept in a nutshell: You put the money away in an IRA tax-deferred while you’re young, carefree, working hard, and making the big bucks. Your big-buck salary vaults you into a higher tax bracket. Your contribute to your IRA helps lower your tax bill every year. Then you become old, carefree, and make the little bucks. Your little bucks drop you into a lower tax bracket, so you pay lower tax on the money you withdraw from your IRA. (The only problem is no one knows if Congress will tinker with tax rates in the future.)
The Roth IRA
The Roth IRA is similar to a traditional IRA in many respects, but if you’re looking for versatility, this is the vehicle you want to drive. The contribution limits are the same as a traditional IRA and the money grows tax-free. (But you can’t contribute to a Roth if your income a certain threshold. Now here’s the big difference: In a Roth IRA, you get no tax break upfront—you pay tax on your contributions now, before you put the money in the account. But you get to withdraw both your contributions — and your earnings on the money — tax-free at age 59-1/2.
Repeat after me: “This is awesome!” Why? Because there are very few vehicles in the world of investing that allow you grow your money and enjoy your profits, completely free of taxes.
Another pro: It’s easier to get your money out of a Roth than a traditional IRA, in the event you need it before retirement. (Although you shouldn’t really think about retirement assets as anything but retirement assets.)
Here’s what you need to keep in mind: There are two components to your retirement savings: the money you put in (contributions) and the interest you earned on that money (profits or earnings). Because you’ve already paid the tax upfront on your contributions, Uncle Sam will let you take them out of your Roth anytime after five years, for any reason, without taxes or penalties. After age 59-1/2, you can take out both contributions and profits tax-free (you must have maintained the account for five years). If you decide to tap the profits from your account before that magic age of 59-1/2, Uncle Sam won’t stop you—but he will slap you with income tax on your profits plus a 10 percent penalty. On the other hand, Uncle Sam recognizes there are legitimate reasons why you may need your profits before age 59-1/2. So he has carved out some exceptions that allow you to take the profits early. You will still pay income tax on the profits, but you can avoid the 10 percent penalty if the money is used:
To put a downpayment on a home (one time only, up to $10,000)
To pay for qualifying college expenses
To pay for big, unreimbursed medical expenses (more than 7.5 percent of your adjusted gross income)
To buy health insurance in the event you are unemployed (you have to be out of work for 12 weeks or more)
If you withdraw a series of equal payments for at least five years until age 59-1/2. (For details on this, see http://www.irs.gov.
Let’s take an example: Rebecca is 25. She wants to save for retirement and would like to buy a home in a few years. She opens one savings account to save money for her home, as well as a Roth IRA. Rebecca contributes $2,000 a year to her Roth IRA for seven years ($14,000 total). Her investment earns $4,000 in interest. Total account value: $18,000.
By age 32, Rebecca manages to save $7,000 to put down on her house – but it’s not enough. She decides to tap the money in her Roth for a down payment for her first home. With the Roth IRA, she can withdraw all of her contributions—$14,000 (no tax or penalty) — and $4,000 in profits (paying ordinary income tax on them).
If Rebecca had invested in a traditional IRA, she could only withdraw $10,000, and would have to pay ordinary income tax on it. See the flexibility?
As you can see, she has more money available to her by investing in the Roth. Now Rebecca’s a smart gal. She knows she needs that money in her Roth for her retirement. So she only withdraws $10,000 to help cover her house downpayment, and leaves $4,000 in the account to continue growing. Now you might be thinking, what’s the big deal? In one case (the Roth), she paid income tax on the money before she put it in the account. In the other (the traditional IRA), she paid income tax on the money after she took it out.
But here’s why the Roth is superior: Over seven years of working, there is a strong possibility Rebecca’s salary has gone up, putting her in a higher tax bracket. That means she would pay higher taxes on the money she withdraws from the traditional IRA to put down on her home.
Because the Roth is so flexible, it also requires discipline. I would discourage you from using your Roth for anything other than retirement. (Suppose Rebecca loses her job and can’t make her mortgage payments? She would have to sell her home, possibly at a loss, or even wind up in foreclosure. That would mean she not only lost her home, but a big chunk of her retirement savings just went down the toilet, too.)
Now go open your IRA!