Tuesday, March 3, 2009

Know What Is Available To You To Save For Retirement – Part 2


Tip #81 - Know What Is Available To You To Save For Retirement – Part 2. In part 1 of this series we discussed the two main vehicles for individuals to save for retirement in the US. They are a 401(k) at work (or 403(b) if you work for a non-profit) and an Individual Retirement Account (IRA) that you set up on your own (or a SEP IRA if you are self-employed). Last time we discussed the 401(k) in detail. Today we will discuss the IRA, of which there are two types – the traditional IRA and the Roth IRA.

An IRA is available to individuals to invest in on their own – they are not set up through your place of employment like a 401(k) is. However, like a 401(k), you can invest in various accounts such as mutual funds, CDs, or money market accounts under the “IRA” heading.

As mentioned above, there are two types of IRAs available in the US – the traditional IRA and the Roth IRA. Today we will focus on the traditional IRA. There are some advantages to investing in a traditional IRA over a Roth IRA or a 401(k) or a not-retirement vehicle, but there are some disadvantages, too. Let’s discuss the traditional IRA in detail:

Currently, you can invest up to $5,000 per year in a traditional IRA (or if you are 50 years of age or older, you can invest $6,000 per year). If you put money away into a traditional IRA, you may be able to deduct that amount from your taxable income each year. In other words, if you put $5,000 into your IRA, then when you or your tax preparer do your tax returns for the year, $5,000 would get deducted from your income to figure out the amount you would be taxed on. However, this tax deduction is subject to some restrictions. It is not allowed if you have a 401(k) or similar retirement plan at work and you make above a certain income. (Note: if you don’t qualify for the tax deduction, you can still contribute to a traditional IRA without the tax deduction.)

If you qualify for this tax deduction, please note that when you withdraw this money in retirement, you will need to pay taxes on that $5,000 at that time. This is called tax deferment. You are essentially delaying payment of your taxes until you retire. Like the 401(k), this is beneficial if you think you will be in a lower tax bracket when you retire.

Another benefit to the traditional IRA is that interest you earn on the account is tax deferred as it is in the 401(k); that is, you don’t pay taxes on earnings until you withdraw the money from the account at retirement. If you had saved this money on your own and not in an IRA account, you would be paying taxes on distributions on a yearly basis.

A benefit of the IRA over the 401(k) is that you can invest the money in almost any investment account that you want. You are not limited to accounts that your company offers. So if you prefer to invest in a mutual fund in Vanguard, you are able. If you want to put the money in a CD at your credit union, you can do that as well, whereas, with your 401(k) you are limited to the investment options that your company offers.

However, there are disadvantages to the traditional IRA, too. You cannot make withdrawals before age 59 ½ and if you do, you will be subject to penalties (there are some exceptions). And at the other end, you must start taking out some minimum withdrawals from your traditional IRA account by the time you reach 70 ½ years. If you don’t start withdrawing this money by that time, you would be subject to hefty fees. Furthermore, a traditional IRA might not be appropriate for you if you expect that your tax rate will be higher when you retire than it is now. In that case, a Roth IRA, which we will talk about in Part 3 of this series, might be more appropriate.

In Real Life (IRL) – As soon as I started working, my dad advised me to start putting money into an IRA. (In order to contribute to an IRA, you must make an income.) At the time only a traditional IRA was offered (not Roth IRAs), and even though my company offered a 401(k), my salary was low enough that I still qualified for the tax deduction. Although I was only 22 years old, my dad told me the earlier I start putting money away for retirement, the better. Trust me when I say, it sounded ridiculous at that time to be saving for retirement, which was about 40 years away. But being that he is older and wiser than I am in all things money, I took his advice. The contribution limit at the time was only $2,000, so that is what I invested.

Now that 20 years have passed (wow!) since then, I am so glad I listened to him and made the maximum contribution each year into an IRA account. Starting in 1989 through 2001 I put in $2,000 annually. After that the limits increased to $3000 from 2002-2004. The maximum allowed was $4,000 from 2005-2007 and since 2008 it is at $5,000. By putting money in this account over the years, I have built up over $70,000 in my IRA accounts. They are in a mix of mutual funds and CDs.

By taking advantage of IRAs on my own and 401(k)s at work, I have been able to sock away a few hundred dollars per month for retirement. By doing this, I have received tax advantages to this savings and have been able to build up my retirement fund slowly so it will be large enough for me to retire. As part of the whole retirement package, IRAs, as well as 401(k)s are worth investigating as a place to invest your money.***

***As is always the case with posts I write on this blog, I am not a financial advisor of any sort. I am just a person who has invested money over the course of 20 years. Any investments you make should be discussed with a competent investment professional.

1 comment:

Emma White said...

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