Start An IRA Now – By the Time You are Richer, You May Not Be Eligible

Jan 5, 2007 by

What’s an IRA? While some might consider it an acronym for the Irish Republican Army, this is an investing blog. Within the context of finance, an IRA is an Individual Retirement Account.

Why open an IRA account?

An IRA enables you to save money towards your retirement, and pay less taxes on that money than if you were to keep it in a savings account or standard stock brokerage account. The government wants you to save money, and gives you a tax break as an incentive to do so. One of the great things about an IRA, unlike many types of pension, is that it is individually held. If you lose your job or change jobs, you can maintain the same IRA.

Funding, Uses, and Restrictions

Funding the IRA

As of 2007, you can contribute up to $4,000 per year to all of your IRA accounts, unless you are over 50 years old, in which case you can contribute $5,000. If you have multiple IRAs of different types, you can only contribute $4,000 (or $5,000)across all of them combined. It is important to start your IRA as soon as possible, as your yearly contributions are limited. Given that most people only expect to work for about forty-five years, at this rate, a maximum of 35 * $4,000 + 10 * $5,000 =  $190,000 could be contributed to the IRA, assuming that the maximum contribution is made each year, and that the contribution limit is not raised (it has been raised in the past). Unlike other retirement strategies, you can’t “catch-up” much in your IRA savings when you turn 50, as you will still be limited to only contributing a fraction of your income each year.

Income Restrictions on IRAs

If you have recently graduated college, and think you eventually will make a large salary, now is the time to contribute to an IRA, not later. While you may have more income in the future, making $4,000 contributions more manageable, by the time you have that income, you may no longer be eligible. Single people may only contribute to an IRA if their Adjusted Gross Income (AGI) is less than $110,000, while married couples may only contribute to an IRA if their Adjusted Gross Income is less than $160,000.

Using money in the IRA

Once money is in an IRA, it can be used to invest in traded securities (stocks), Real Estate Investment Trusts (REITs), certificates of deposit (CDs), or other common financial instruments. Cash can also be held within an IRA account. As investments can be made, it is possible for people to obtain passive earnings (or losses) on their savings.

Restrictions

There is a financial penalty for withdrawing money from an IRA before reaching the age of 59.5. Likewise, there is a penalty if certain minimum withdrawals are not made after reaching age 70. There are a number of exceptions under which withdrawals can be made before age 59.5 without penalty. For instance, money can be withdrawn penalty-free to fund the college education of a child or grandchild, or to buy a first home (up to $10,000).

Types of IRAs

There are many types of IRAs, which you can read more about at Wikipedia. However, most of the varieties are subtypes of the two main types of IRAs: Traditional IRAs and Roth IRAs.

Traditional Individual Retirement Accounts

Traditional IRAs enable you to make contributions with pre-tax assets. That is, you earn money at your employer, and that money is then contributed to the IRA before it is taxed. Once the money is in the IRA, any transactions using the money (i.e. buying and selling stock with money in the IRA account) are not taxed. Thus, when trades are made within an IRA, there are no short-term gains taxes. The downside of a Traditional IRA is that the money contained in it is eventually taxed when it is withdrawn.

Roth Individual Retirement Accounts

Unlike Traditional IRAs, contributions to Roth IRAs are taxed before they are entered into the account. As is the case with Traditional IRAs, any transactions made with the money while it is within the account are not taxed. However, as the money was taxed before it entered the Roth IRA, it is not taxed when it leaves.

Which IRA is right for you?

In summary, Traditional IRAs enable you to make untaxed contributions, but taxed withdrawals, while Roth IRAs enable you to make taxed contributions, but untaxed withdrawals. Which is a better choice for you? If you anticipate being at a higher marginal tax rate when you withdraw the money, a Roth IRA is better. If you anticipate being at a lower marginal tax rate when you withdraw the money, a Traditional IRA is better. Thus, if your salary is expected to increase, and you plan to continue having other capital gains (or a salary) when you withdraw the money, you are probably better off with a Roth IRA. If you plan to retire before you withdraw the money, or experience a decline in capital gains (or salary) by the time you make the withdrawals, a Traditional IRA may be a better choice.

There are other restrictions and details that one must consider when owning an IRA. To read more from the definitive source, visit the Internal Revenue Service.

2 Comments

  1. Scott

    If you have too much of your total investment portfolio “locked-up” in your IRA, do you risk running out of funds before you can withdraw from your IRA without penalty? I’m thinking of someone who contributes every penny they possible can as they age, but then not having any money in case they want to retire early, travel, etc., before they reach age 59 1/2.

  2. Here are the official rules on when you can take out money early without penalty:
    http://www.irs.gov/publications/p590/ch01.html#d0e7978

    You will note that it is permissible to use money from the IRA to pay for your kids’ tuition, buy a first home, survive in a time of disability, or pay large medical expenses. There is a penalty for early retirement and travel. Why? The government is giving you “free money” (i.e. lower taxes) for saving, as it would like to encourage you to save for your retirement. The government understands that there are non-luxury reasons people may need to withdraw from their savings, and does not penalize people for doing so. However, vacations and early retirement are luxuries that the government does not feel the need to subsidize through IRA-related tax-breaks. You can withdraw money at any age, for any reason… if the reason is penalized, you will have to pay 10% additional tax on the distribution.

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