Jul 12, 2010

What is an IRA? (Carole)

You probably already know that IRA stands for Individual Retirement Account.

It is the U.S. Government's way to encourage each citizen to save up to $5,000/year (or $6,000/year if you are 50 years old and older) with some pretty nice tax benefits.  This means a married couple can save up to $10,000/year (or $12,000 if you're both 50 or older).

There are two types of IRAs.  Traditional and Roth.  They are quite different.  Here are the basic concepts of each.

Roth IRA
*  If you file your taxes singly, you have to earn $120,000 or less that year to invest in a Roth IRA.  If you are married and filing jointly, you have to have a combined income of $177,000 or less for the year.  These amounts change nearly every year, so check with your investor for the current limits.  In fact, I found various $ limits mentioned for 2010, but the above amounts seemed to be the most accurate.  Investing through a government plan is a bit confusing!  A good banker or broker will easily navigate you through it all.

*  Your contribution is NOT tax deductible, but ALL the principal and interest earnings are tax free when you withdraw them after age 59-1/2.

*  You can withdraw your principal (the money you actually invested in the Roth IRA) at any age with no penalty.  But you will pay penalties if you withdraw any of your interest earnings before age 59-1/2

* Your Roth IRA money can be invested in almost anything:  stocks, bonds, CDs, investment property. . . through a bank or brokerage.

Traditional IRA
*  There is not an income requirement to invest in a Traditional IRA.

*  Contributions ARE tax deductible.  However, taxes (on principal and interest earned) will be charged when you begin to withdraw your money.

*  You cannot withdraw any of your contribution or interest earned until age 59-1/2.  You do not have to withdraw at that age, but MUST begin withdrawing by age 70-1/2.  If you withdraw your money before you are 59-1/2 there is at least a 10% penalty.  Ouch.

*  Again, your Traditional IRA can be invested in almost anything:  stocks, bonds, CDs, investment property. . . through a bank or brokerage.

To max out your yearly contribution would be a monthly investment of $416.67 per person (or $500 per person/month age 50 and older).  However, your contributions can be made in any increment at any time, and you do not have to reach the $5,000 limit.

$10,000/year savings might not sound like it will ever amount to much, but if you can consistently put that away in either kind of IRA from age 40 until you retire at age 65, you'll have over $1,000,000.  Just think how much you'll have if you start investing in your 20's!!!  The earlier you start saving any amount in an IRA, the more money you'll have at retirement -- remember, compound interest is your very best friend over the long haul.


Kimberly F. said...

Thanks for explaining this is in a brief, not too detailed way!

Melanie said...

Great explanation. One other detail for the Roth IRA is that the account must exist for 5 years before it is officially treated as a Roth IRA. So, if you take a principal withdrawal before age 59 1/2, then be sure the account is at least 5 years old! Otherwise, it can create a taxable event.

Also, after certain higher six figure income levels, the traditional IRA is not tax deductible but still beneficial because there are no taxes on the growth until you begin to spend the money after 59 1/2.

Tara said...

I've always been confused on the differences between those. Thanks for explaining.

Merry said...

Quick question: If you and your husband put in $10,000 per year for 25 years (from age 40-65), you've contributed only $250,000 to the IRA. Do you really get returns of 400% in interest? That doesn't seem possible, but that's what you'd need to end up with $1,000,000 after 25 years.

Anonymous said...

Remember that it is COMPOUND interest. Each year you earn interest on your principal AND previous interest. That's what make the huge difference. The interest rate in this calculation is about 8%.

You can go to bankrate.com and use a savings calculator and put in your numbers and see how it works.