Investing Options Series: IRAs

Posted on 16. Oct, 2006 by in Saving & Investing

What Are They?
An individual retirement account (IRA) is a personal savings plan that provides some tax advantages to allow you to save for retirement. The concept itself is simple, but sometimes people get bogged down in the details. Hopefully we’ll answer some of the more common questions here.

How Does an IRA Work?
A traditional IRA allows you to contribute a specified amount of pre-tax income each year ($4,000 if you’re under 50) to your savings plan. All of your contributions and earnings accumulate tax-free; however, your withdrawals at retirement are taxed as income.

Once your money has been contributed to an IRA, you can begin to direct your broker or “IRA custodian” where to invest your money. You can use your IRA dollars to purchase most types of securities (stocks, mutual funds, etc.) and even some non security financial instruments.

Besides their favorable tax status, IRAs are also protected during bankruptcy like many other retirement accounts.

Different Flavors
Just like every other investment under the sun, there are a number of different IRAs – each with its own strengths and weaknesses.

  • Traditional IRA: contributions are made with pre-tax assets and earnings are also tax-free. Withdrawals at retirement, however, are taxed as income.
  • Roth IRA: contributions are made with after-tax assets but your earnings and withdrawals are usually tax free.
  • SEP IRA: an employer established and funded Simplified IRA, where the employer can put up to 15% of your compensation into a special IRA account. Sole proprietors may also establish these plans for their own benefit.

Short or Long-Term Investment?
Whenever we’re talking about retirement we’re talking about long-term investing. And you should keep this fact in mind when deciding how to invest your IRA funds. Sure, you can play the market a bit more while you’re in your 20s, but if you keep up an aggressive investment strategy beyond then, you could be disappointed at the nest egg you’ve built up.

Potential Risk
The biggest risk associated with an IRA is the return on your investment – which is decided in large part on the types of investment decisions you make. The stock market has been a proven ground for long-term investment, but it also has its ups and downs…

Another thing to watch out for with IRAs is what I’ll call the “little things.” These are things like brokerage fees, following the contribution and withdrawal rules, etc. For example, Uncle Sam makes you start taking cash out of your IRA at age 70 1/2. If you neglect to do so, the IRS will take 50% of what you should have withdrawn without so much as a “thank you.” On the flipside, if you touch that money before age 59 1/2, Uncle Sam will fully tax your distributions as ordinary income and slap you with another 10% penalty just to get the message across that retirement savings are for just that… retirment.

Potential Return
The “base return” of your IRA will depend completely on how well you invested it. If the stocks or mutual funds did well during the 30 years you contributed, then you will have invested wisely and you will be pleased with your return. If, however, you took a more aggressive investing strategy and your stocks slid, you’re going to be disappointed.

However, the main benefit of an IRA is not the “base return” but the fact that you can earn a return with a tax delay (note that IRAs are not “tax free” – you’ll have to pay taxes either at the time you contribute or at the time you withdraw your money). For example, if you believe that you’ll be in a 15% tax bracket at retirement age, while right now you are in a 30% bracket, then you’re going to effectively save 15% in taxes at the time you withdraw your funds.

Who is this a Good Investment For?
Everyone! Unless you’re only a few years from retirement and long-term investments aren’t going to do you any good anyway, IRAs are a great long-term investment for everyone. You’re going to have to think about which flavor is best for you (traditional IRAs are typically for lower-income brackets) but regardless of your situation an IRA is a very smart investment.

Other Online Resources:
This post is in no way meant to be comprehensive, so be sure to do your homework before contributing to an IRA. However, here are a few places that might be able to help:

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One Response to “Investing Options Series: IRAs”

  1. arkadaşlık

    22. Oct, 2006

    Besides their favorable tax status, IRAs are also protected during bankruptcy like many other retirement accounts.

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