An Individual Retirement Account, or IRA, is one of the best and easiest ways to begin saving money for retirement. These vehicles also have the added advantage of receiving favorable tax treatment from the government. Of course, many would be savers think that they will be able to comfortably retire on their social security benefits alone. Unfortunately, for most people, this is a myth which demands additional action.
According to government statistics, the maximum benefits that social security will provide may not be enough to cover typical retirement expenses. This also assumes that the program will continue to function and pay benefits at the same rate. There is currently much speculation about how to reform this program, so there is no guarantee that there will be enough money to fund it within just a few short years.
It is also a fact that social security was never intended to be the only funding source for retirement. The framers envisioned a combination of personal savings, pensions and social security. However, it seems that few Americans save as much as they should and less than half will collect a pension.
The IRA can help
Using an IRA is an excellent way to put money aside without having to pay taxes on it until much later or allowing it to grow tax free. This way money is able to grow and accumulate with the continual burden of taxes. The hope here is that a saver will be able to have their money grow for years in a tax free situation. Only once withdrawals begin will taxes need to be paid (if it is a traditional IRA). At this point, most savers will be in a lower tax bracket.
As with anything else which involves the government and taxes, there are specific rules. It is definitely recommended that a qualified financial advisor is consulted before opening an IRA. Generally speaking, individuals will have contribution limits. Those who are 50 or older will usually be allowed an increased limit, called a “catch-up” contribution.
Types of IRA’s
There are several different types of IRA’s which can be used by individuals. These include the traditional IRA, the Roth IRA and the education IRA. Each form has specific rules, contribution limits and requirements.
- Traditional IRA: Almost anyone is eligible to establish and contribute to a traditional IRA, as long as they received taxable compensation during the year (and were not 70 ½ years old by the end of the year). There are contribution limits, which generally increase every few years. These contributions may reduce taxable income and may even generate a tax credit or other benefits. Through tax deferred compounding, investments have the potential to grow exponentially. Principal, earnings and gains will not be taxed until they are distributed. Generally, those holding these accounts must begin taking withdrawals once they reach age 70 ½.
- Roth IRA: Under this plan, contributions are made into the account on an after tax basis. Additionally, if the requirements and eligibility rules are met there are no regulations about when distributions must be taken; money may be left in such an account indefinitely. Investments will grow tax-free and any principal withdrawn will not be subject to tax. To contribute to such an account there are generally income requirements (according to AGI as reported on tax forms). There are also contribution limits and catch-up contributions, similar to a traditional account.
- Education IRA: These accounts are also known as Coverdell education savings accounts. Contributions are limited and made on behalf of a child under the age of 18. These contributions are not deductible although the amounts deposited grow tax free until distribution. There are also income requirements to determine who is eligible to establish such an account (using the AGI as reported to the IRS).
An individual retirement account can be a fantastic way to save money for retirement. Of course, it should be part of a well-diversified overall income plan and strategy. Being able to contribute money to an account, either on a pre or post tax basis, and then having that money grow and compound while delaying any tax is a great way to seriously grow almost any type of portfolio. All investors and savers are strongly encouraged to look into these retirement accounts today.