Paycheck Chronicles

Retirement Week: IRAs


Most people have heard of Individual Retirement Arrangements (IRAs).  As we build our bucket of retirement income, IRAs play an important role because they are available throughout a career.  Here's the short version of everything you need to know about IRAs.

Who Can Open An IRA?

Anyone who has earned income can contribute to an IRA, and the non-working spouses of workers can also contribute through a spousal IRA.  Contributions are limited to the amount of documented income, or the yearly limit.  All income levels can contribute to a traditional IRA, but there are income limits for Roth IRAs.

How Do IRAs Work?

You can open an IRA at most financial institutions, including banks, credit unions, and investment companies.  Because you can choose to invest your money into a wide variety of investment types, but not every company offers every type of investment, you should consider what type of investment you want before opening your IRA account.  Possible types of investments includes things as simple as Certificates of Deposit, slightly more complex mutual funds, or a portfolio of individual stocks and bonds.

One area where people are often confused is thinking that the IRA itself is the investment when it is really just the type of investment account.  Basically, the IRA designation is just a wrapping around an investment that provides tax advantages.

Why Is An IRA A Good Idea?

IRAs are tax-advantaged retirement accounts, meaning that you can get tax benefits from saving retirement funds in an IRA. You can choose between a traditional IRA, which allows you deduct the contributions from your taxable income during the year in which you contribute, or a Roth IRA, where you pay the income taxes up-front and then all withdrawals are tax-free.  If you can combine a Roth IRA with tax-free pay earned in a designated tax-exempt combat zone, its tax-free in AND tax-free out!

One of the other major benefits of an IRA is that they are available for contributions throughout your working life and aren't tied to the plans of a specific employer.  This gives you more years to contribute, which is always a good thing.  A young worker who puts just $1,000 into an IRA each year, starting at age 16 and continuing through age 65 will have over $400,000 saved by retirement age.  If the same worker waits until he gets a "real job" at age 26, the same $1,000 per year will be less than $200,000 at age 65.  (Both projections assume a 7% return.)

When Do You Get The Money Back Out?

The idea of tax-advantaged retirement accounts is that you are savings the money for retirement, but there are exceptions and variations on every rule.

With a traditional IRA, you can begin distributions at age 59 1/2, and you must begin distributions by aged 70 1/2.  If you take money out of your IRA account prior to age 59 1/2, you'll pay a 10% penalty plus the regular income taxes.

Roth IRAs are significantly more flexible, in many ways.  Generally speaking, the funds contributed to a Roth IRA can be withdrawn at any time without penalty, as long as you don't accidentally withdraw some of the earned income as well.  Pre-59 1/2 withdrawals of earnings will incur the same 10% tax penalty as a traditional IRA.  Additionally, there are no required distributions of Roth IRAs, which means that you won't be required to withdraw funds even if you don't need them.

There are some exceptions to the withdrawal rules for IRAs, and the details vary by account type and the reason for the exception.  If you are considering trying to use IRA money to pay for certain expenses such buying a house, paying for college, or paying medical expenses, you need to get expert advice to ensure that you understand all the details.

Modern retirements require a variety of different types of investments to provide different streams of income.  IRAs can fill the gaps between employer-sponsored retirement plans with tax-advantaged benefits.  If you don't have an IRA, I encourage you to open one and start contributing now.

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