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The Beauty of IRAs

An IRA is a great way to save for the future, but only about 15 percent of U.S. households are contributing to one, according to a 2009 report by the Investment Company Institute. That’s a shame, because an IRA is a tax-deferred account that can help you invest for retirement—whether you are just starting out, in the middle of your working years, or heading toward the finish line.

What is an IRA anyway?
First things first: An IRA—technically, “Individual Retirement Arrangement,” though most people call it an account—is not an investment or product itself. Instead, think of it as a container that can hold almost any type of investment.

You get to choose the investments that go into your IRA, perhaps with the help of a financial advisor. You can fill it with a mix of annuities, mutual funds, stocks, bonds, CDs, or cash—the same things you might have in any other type of investment account.

The difference is that because the government wants you to save for retirement, IRAs provide a way to shelter more of your money. Depending on what type you choose, you can either save on paying taxes now or enjoy tax-free earnings in retirement.

Why do you need one?
An IRA may be a smart choice if your employer doesn’t have a retirement plan, but it can also make sense even when you do have a plan at work—especially if your employer doesn’t match your contributions. With the future of Social Security under scrutiny and company pensions becoming increasingly rare, an employer’s plan may not be enough to build the savings you’ll need for retirement.

An IRA gives you more investment choices, too. For example, some 401(k) plans don’t offer guaranteed savings annuities. Created specifically for retirement, they guarantee you against loss and—when you’re ready—can be turned into retirement income that’s guaranteed to last the rest of your life. Any fixed annuity guarantees are subject to the claims-paying ability of the insurer. Since annuities are sold by insurance companies, the financial strength of the company providing the annuity is an important consideration.

If you switch jobs, rolling your 401(k) assets into an IRA—rather than leaving it behind or rolling it into your new employer’s 401(k)—gives you more freedom to choose how to diversify your hard-earned money.

Roth vs. Traditional
There are two basic types of IRAs: Traditional and Roth. If you earn income and are younger than seventy-and-a-half years old, you’re eligible to contribute to an IRA. You won’t owe any taxes on interest or other gains in your account until you start making withdrawals, and you may even get to take a tax deduction this year for the money you put in. Once you reach age seventy-and-a-half, the government mandates that you begin to take distributions from your Traditional IRA, also called required minimum distributions.

If you’re an active participant in an employer retirement plan, a Traditional IRA is fully tax-deductible only if your adjusted gross income is below these thresholds for 2010: $56,000 to $66,000 for single taxpayers; $89,000 to $109,000 for married filing jointly; and $0 to $10,000 if you’re married filing separately. If it’s within the range, a portion is deductible; if it’s above the range, you can’t deduct any of it.

With a Roth IRA, contributions are not tax-deductible, but qualified withdrawals are generally tax-free once your account has been open for at least five years and you’ve reached age fifty-nine-and-a-half. Earnings are subject to ordinary income taxes and penalties before age fifty-nine-and-a-half. Owners of a Roth IRA are not subject to required minimum distributions. To be eligible for a Roth IRA, your adjusted gross income must fall within IRS limits. If you like what the Roth IRA offers, but don’t meet the income limits, consider converting to a Roth IRA. Conversions from a traditional IRA to a Roth are subject to ordinary income taxes. Please consult with a tax advisor regarding your particular situation.

The maximum annual contribution for both kinds of IRAs in 2010 is $5,000, or $6,000 if you’ll be fifty or older by the end of the year. You can contribute to both kinds in a single year, but your combined contributions can’t exceed the same limit. You have until your tax filing deadline—usually April 15—to make a contribution for the previous tax year.

How to choose?
Which IRA is right for you? The answer depends on what you think your future tax rate will be.

If you believe income tax rates will rise or that you’ll have more income in retirement and fall into a higher tax bracket, then consider a Roth and pay taxes on the money now. If you expect to be in a lower tax bracket in retirement—or you don’t qualify for a Roth—a Traditional IRA may be a good choice.

Since no one has a crystal ball, one approach that makes sense is to diversify your retirement savings from a tax perspective. Build a mix of retirement investments that offers the advantage of providing tax relief and flexibility now and in the future. This would include:

  • Pre-tax accounts, like Traditional IRAs or 401(k)s.
  • Tax-deferred accounts, such as a Roth 401(k) or Roth IRA.

Originally published on USAA