I’m a huge fan of Individual Retirement Accounts for a multitude of reasons, but a main reason is that your investments can increase quick thanks to the tax-sheltered or tax-free growth they offer. They’re also wonderful assets to bequeath to heirs because the tax advantages they offer pass to your beneficiary.
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I’m not alone: today there is more money in IRAs than in any other kind of retirement account- from government pensions to 401(k)s.
According to the Investment Company Institute (ICI), nearly 49 million American households include one or more IRA owners. “Traditional” IRAs remain the most common with one out of three households owning at least one. But Roth IRAs, which first became available 15 years ago, are steadily gaining in popularity and can now be found in 17% of all households.
Are You “Traditional”?
Anyone can contribute to a traditional IRA, which was first introduced in 1974. This type of account offers the benefit of tax-deferred growth; you don’t owe income tax on the gains your investments earn until you withdraw them, presumably years in the future when you are retired.
If you meet the income requirement, you can deduct your annual contribution when computing your federal taxes. (1) On the other hand, if your income exceeds the limit, you can still make an after-tax, i.e. non-deductible, contribution.(2) Keep in mind that if you are married, it’s your joint income that matters--not how much you as an individual earn. Whether or not you can deduct your contribution, the earnings that your investments make grow tax-deferred.(3)
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Is “Roth” Right for You?
Roth IRAs reverse the tax treatment and you don’t have the option to deduct your contributions. However, if you meet the income requirements, all of the gains your investments earn can be withdrawn completely tax-free.
Roth IRA withdrawals have other advantages, such as reducing the taxation of Social Security benefits and the chance you’ll be hit with the new 3.8% Medicare surtax.
Follow the Money
Of course, making an annual contribution to either type of IRA requires having the extra cash to do so. According to ICI, in tax year 2011, “Although most U.S. households were eligible to make contributions, few did so. Only 16 percent of U.S. households contributed to any type of IRA.” In reality, most of the money in IRAs comes from rollovers, investments that are transferred from employer-sponsored retirement accounts when someone changes jobs or retires.
In fact, the primary reason people roll over retirement money to an IRA is that they want to continue to get the tax advantages their investments received when they were in their company plan.
If you want to make an IRA contribution for 2012, you must do it before April 15. The maximum amount is $5,000. Individuals age 50 or older can add another $1,000, for a total of $6,000.
Keep in mind that this is the most you can contribute; you don’t have to max out.
IRA contribution amounts are periodically adjusted for inflation, and starting with 2013 contributions, the maximum goes up to $5,500. The so-called “catch up” contribution will remain the same, i.e. $1,000. The window for making a 2013 contribution to an IRA runs from Jan. 1, 2013 through April 15, 2014.
But why wait until the last minute? The reality is, most of us don’t usually have an extra $5,500 sitting around on any given date. And if we did, we’d probably spend it on something offering more immediate gratification- a vacation, to reduce debt, etc.
The Auto-Pilot IRA
A less painful way to make your IRA contribution is to set up an automatic payment. You simply decide how much you can afford to what you can afford to pay each month- $100? $400? On the day you choose, this amount will be electronically deducted from your bank account by your IRA custodian. When April 15th rolls around next year, you don’t have to worry about coming up with a chunk of cash.
No Salary? No Problem! (If You’re Married)
If you are married and one spouse- for whatever reason- is not participating in the paid workforce, an IRA offers that individual the opportunity of having their own retirement account. You can qualify to contribute to a “spousal IRA” based upon the income that your partner is earning.
If your adult-aged child plans to work over the summer, he or she can have an IRA. A tax-free Roth would be an excellent option because the money isn’t necessarily locked up until you’re 59½. After five years, qualified withdrawals would be tax and penalty-free in case money were needed for graduate school or a first-time home.
Of course, the best scenario is for the investments to remain in the account until retirement. Assuming an annual return of 7%, a single contribution of $5,000 made with summer break earnings this year, would grow to more than $105,000 45 years from now when your college student is approaching retirement. And if that $5,000 was in a Roth IRA, every cent would be tax-free.
If your college student will be working during summer break, why not propose that mom and dad offer to match-- up to the maximum- whatever their student contributes to an IRA? Or, parents or grandparents might fund the entire contribution to a traditional IRA and the student could take the tax deduction.
Opening an IRA for a qualifying child is a way to begin a conversation with a young adult about a variety of real-life financial issues- such as the need to save for retirement, investing in general and the value of compounding.
1. Most, but not all, states allow you to deduct a contribution to a traditional IRA, so check with a tax professional familiar with the laws of your state of residence.
2. The most current information on IRAs- including the income limits for both traditional and Roth accounts- can be found in IRS Publication 590,
3. Your after-tax contributions are not subject to income tax again when withdrawn.