The Basics of IRAs

The Basics of IRAs Ideally, a long-term retirement savings program is comprised of 3 basic components:
  1. Personal Savings
  2. Company Pensions
  3. Social Security
With Social Security being well on its way to bankruptcy within the next 4 decades (just read your statement if you don't believe me), and company pension plans quickly becoming a thing of the past; personal savings must be maximized in order for us to survive in retirement. According to a recent survey, '95% of Americans are uneasy about their financial situation in retirement and 42% say their biggest fear is running out of money prematurely.' (National Underwriter, April 4, 2005)

The term "personal savings" includes both your contributions to your company's 401(k), (excluding matches because matches can vary by employer, and also a growing number of companies have stopped offering them) and contributions to your own IRA. This article will thoroughly discuss how IRAs work and how they can benefit you.

The term "IRA" stands for Individual Retirement Account. An IRA is a tax sheltered account that allows your money to accumulate with out paying taxes. All IRAs fall into 2 basic camps: Tradional IRAs and Roth IRAs. Listed below are the primary differences of both:

Tradional IRA Roth IRA
Eligibility Anyone under age 701/2 w/ earned income. Nonworking spouses are eligible. Anyone w/ earned income. Nonworking spouses are eligible.
Tax Deductible Yes No
Withdrawals Distributions taxed as ordinary income. Distributions prior to age 591/2 are subject to a 10% penalty, w/ exceptions Distributions are tax-free & penalty-free if held for 5 years or more and taken for 1st time home purchase ($10,000 lifetime limit) other exceptions also apply
Distributions Distributions must begin by age 701/2 No deadline for distributions

The maximum contribution limit for an individual who invests in an IRA is $4,000 per year, for people over the age of 50 the maximum contribution for tax year 2006 is $5,000 per year ($4,000 + an additional $1,000 from the 'catch'up? provision).

The maximum contribution limits for the following years are:

2005 = $4,000 / + $500 catch-up if over 50 2006 = $4,000 / + $1,000 catch-up if over 50

2007 = $4,000 / + $1,000 catch-up if over 50 2008 = $5,000 / + $1,000 catch-up if over 50

Mutual Funds are the popular choice of investments for IRAs, primarily for the diversification factor and because you have experienced professional fund managers handling your money.

The following is an example of how an IRA can be of benefit to you:

Let's say both you and your spouse each invest $4,000 a year into a 'Growth' oriented portfolio of mutual funds. A good average annual return for the typical growth portfolio over the long'term (10 years+) would be about 10% a year. In 30 years your combined $8,000 annual investment would grow to about $1,590,000 in an IRA (tax-deferred account) as opposed to $951,500 in a voluntary (taxable) account. If your income allowed you to qualify for a Roth IRA, then come retirement time your $1.5 million fortune could be received tax-free! In regards to tradional IRAs, while some people with exceptionally high incomes may not qualify for the tax deduction, everyone qualifies for the tax deferred growth. Contrary to popular belief, you don't need to invest a lot of money to start saving for retirement. Most investment companies will allow you to open an IRA for a lump sum of about $1,000 or for as little as $50 a month. Everyone's individual situation is different, so talk to your local financial representative to find out which type of IRA is right for you.