Happy Friday everyone! After a few weeks (eh, month and a half) hiatus, I’m happy to report Financially Savvy Friday is back. In my last post, I talked about how to make the most of your 401K. But the reality is out of over 120 million American workers, as of 2012, only 52 million (43%) were active 401K participants. The rest, if they plan for retirement, do so via employer-sponsored retirement plans (both defined benefit (DB) and other defined contribution (DC) plans, besides 401Ks, with private-sector and public employers), individual retirement accounts (IRAs), and annuities. Today, I’m going to address the IRA, a tax-advantageous retirement account available to almost anyone with taxable income.
What is an IRA?
IRA stands for Individual Retirement Account. As of the end of 2014, the US Retirement Market represented assets totaling $24.7 trillion, representing 36% of total household financial assets. IRAs are the largest component of that market, totaling $7.4 trillion.
How do I start an IRA?
You can open an IRA with any major financial institution, from your regular bank to brokerage houses, or mutual fund families, like Fidelity and Vanguard. Before deciding on where to open your account, check the account requirements. Most have minimum opening balances, which may or may not be waived if you set up regular, recurring deposits to the account.
The other key factor to consider is fees. Even if the account itself does not have fees charged to it directly, once the funds are there, you will want to invest them. The various investment options will have fees associated with them. IRA assets can also be invested across a range of investment vehicles, including single equities or bonds, basic CDs and mutual funds. If investing directly in individual stocks or bonds, there will be fees per trade. In 2014, nearly half of IRA assets were invested in mutual funds. Be sure your account provides you access to no-load mutual funds (funds that do not charge an upfront fee), and range of fund strategies and asset classes so your savings will be well diversified. This often makes IRA accounts directly with no-load mutual fund families, the most attractive option.
IRS Rules for IRAs
Contribution Limits, Tax Deductions and Benefits
You can contribute assets to an IRA annually so long as you have taxable income and are under the age of 70 1/2. Contributions are tax-deductible. However, your annual contributions are capped by the IRS. You may not contribute more than:
- $5,500 (for 2014 and 2015), or $6,500 if you’re age 50 or older by the end of the year; or
- your total taxable compensation for the year
Remember the huge benefits of pre-tax investing? The average household pays an effective tax rate of about 20%. After taxes, the $5,500 you could have invested pre-tax in an IRA, is only $4,400. Compounded over the 20 years at the average equity return of the last two decades, that’s over $5,000 of foregone investment income, in addition to the $1,100 you lost to the government. Repeat that every year for 20 years, and that’s multiple year’s worth of lost retirement income!
Deductions, however, are limited and may be eliminated entirely depending on your income level and if you participate in an employee-sponsored plan, like a 401K already. This does not prevent you from making the contribution, just from it being completely tax-deductible. There is still plenty of benefit – your investment income does still accrue with no taxation until you begin taking distributions in retirement.
Withdrawals and Distributions
Withdrawals can be made from your IRA without tax penalty beginning at age 59 1/2. Withdrawals are subject to income tax. Withdrawals made before age 59 1/2 are subject to a 10% penalty, in addition to income tax, though some exceptions may be made. Traditional IRAs also require you to take minimum distributions beginning at age 70 1/2.
A Rollover IRA is typically used to transfer assets from another retirement vehicle, to preserve the tax-deferred treatment of the earnings to date. Going forward, it works the same as a Traditional IRA. As an example, if you have a 401K and choose to leave the employer, you can elect to leave your 401K assets in their plan, or transfer it to a Rollover IRA. If their plan is ever terminated, you will be forced to withdrawal the funds, and you can place them in a Rollover IRA to defer all taxes to retirement.
Roth IRAs have different tax treatment than a Traditional IRA. Annual contribution limits are the same as a traditional IRA, however, contributions are not tax deductible in the year of contribution. Instead, all earnings and withdrawals are tax-free in retirement. If you don’t need the tax deduction today, and you believe future tax rates will be higher (most likely), this is an attractive option.
Another key feature of Roth IRAs that often make them attractive estate planning vehicles – unlike a Traditional IRA, Roth IRAs do not have minimum required distributions at any age. So, if you don’t need the money, it can continue to grow tax-free throughout your life. Your designated beneficiary will not owe tax on withdrawals and can opt for distributions over many years.
There is a catch – eligibility for participation in a Roth IRA is capped by income level. If your reported adjusted gross income is more than $193,000, married, or $131,000, single for 2015, you are not eligible to contribute to a Roth IRA.
Why use an IRA?
If you are not eligible for or are not offered retirement benefits via your employer, an IRA is a great way to access the same preferential tax treatment provided by many employee-sponsored plans, like 401Ks. Even if you do participate in a 401K, whether your initial contributions are tax deductible or not, it still provides tremendous tax-advantaged saving opportunity. All earnings accrue and compound tax-free – few other traditional savings or investment accounts provide that option.
So, now you know the basics of IRAs… do you feel a little more financially savvy? Next week, I will be talking about Defined Benefit Plans, the final primary type of retirement savings I have yet to address. I will focus primarily on how to determine the health and security of your plan, so be sure to check back next Friday if your retirement is tied to Defined Benefit Plans.