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Make the Most of Your IRA
Investors have two options for their individual retirement
accounts (IRAs). The first option is a traditional IRA, the second option is
a Roth IRA (named for the account's congressional sponsor), which features --
among other benefits -- the ability to accumulate tax-free earnings under
certain circumstances. In this report we'll discuss the features of the traditional
IRA. You may want to review material outlining the Roth IRA -- or talk
to your financial planner -- before you make a decision as to which IRA
is right for you.
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What Is a Traditional IRA?
An individual retirement account allows your investment earnings to grow tax deferred until withdrawn, typically at retirement. Generally, if you have earned income or receive alimony, you can establish as many IRA accounts as you want prior to the tax year in which you reach age 70 1/2. You may also have an IRA even if you participate in a qualified pension, profit-sharing, or other retirement plan. Your entire contribution may not be deductible on your income tax return, depending on your income.
IRAs offer two distinct advantages in terms of taxes:
potential deductibility of contributions and tax deferral on investment earnings.
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Rules on Contribution Limits
Currently, the annual contribution limit is $4,000 (in general, married couples filing jointly can contribute a total of $8,000, even if only one spouse has income). In 2008, it will increase to $5,000 per taxpayer. Thereafter, the contribution limit will be adjusted for inflation. Individuals aged 50 and older are now able to take advantage of new "catch-up" contributions to IRAs. The allowable catch-up contribution is $1,000 per year beginning in 2006.
In addition, you can open an IRA or make contributions
to an existing IRA as late as the deadline for filing a tax return for that
year. That means you would have until April 2007, to make your 2006 IRA
contribution.
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Tax Treatment of IRAs
Contributions to an IRA may or may not be deductible
from your earned income in a given tax year depending on your situation. As
part of the Taxpayer Relief Act, income limits that currently restrict the deductibility
of contributions will gradually increase. Also, IRA deductibility is no longer
affected by whether an individual's spouse is eligible to participate in an
employer-sponsored retirement plan.
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The Magic of Tax-Deferred Compounding
The ability to make tax-deductible contributions to your IRA can help your current tax situation. But you may want to invest in an IRA whether or not your contributions are deductible. Why? The real advantage of investing in an IRA is tax-deferred compounding of your investment earnings over the long term.
For example, if you had contributed $100 every month for 30 years to a tax-deferred IRA, then paid 25% tax on your withdrawals at retirement, you could have netted $112,522, assuming a 8% average annual rate of return. However, in an account that's taxed annually at a hypothetical rate of 25%, your total would have been only $100,954 -- almost $12,000 less just because you had to pay taxes up front!
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Change Jobs, But Keep Your Retirement Money
IRAs can also come in handy when you're about to leave jobs and need to move your 401(k) money. If your former employer requires that you withdraw your retirement money, you can move your distribution safely from your former employer's qualified retirement plan into a rollover IRA and avoid owing current income tax on the distribution.
If you choose to physically receive part or all of your
money and do not replace the entire amount within 60 days, you will be subject
to penalty fees and taxes on the amount kept. Clearly, you can avoid many headaches
and keep your retirement nest egg intact by making sure your hands never touch
your retirement money until age 59 1/2.
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Consult Your Financial Advisor
An IRA can become the cornerstone of your personal
retirement savings program, providing the foundation for your financial security.
That's why it is so important to start planning today. Consult with your financial
advisor to help you determine how an IRA could help make your financial future
more secure.
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Summary
- If you have earned income or alimony, you can establish as many IRA accounts as you want prior to the tax year in which you reach age 70 1/2.
- Contribution limits are $4,000 or 100% of your earned income, whichever is less. Special "catch-up" contributions are also available to older Americans.
- You can open an IRA or make contributions to an existing IRA as late as the tax-filing deadline for that year.
- Income limits restricting the deductibility of contributions increase annually.
- IRA deductibility is not affected by whether a spouse is eligible to participate in an employer-sponsored retirement plan.
- A major advantage of investing in an IRA is tax-deferred compounding.
- By April 1 following the year in which you reach age 70 1/2, you must begin withdrawals from your IRA.
- Individuals under the age of 59 1/2 can make penalty-free withdrawals to pay college expenses for themselves, a spouse, children, or grandchildren.
Checklist
- Make your choice: traditional IRA or Roth IRA?
- Consider consolidating retirement assets by transferring (or "rolling") money from a former employer's retirement plan into your IRA.
- If you're at least 50 years old, try to take advantage of "catch-up" contributions that allow you to set more aside for retirement.
- Choose appropriate investments for your IRA and review your strategies once or twice a year.
