A recent study from TIAA-CREF reveals that people don’t really know what IRAs are or how they work. As a result, people miss out on the opportunity to use these retirement planning tools (the other reason they don’t use them is that they don’t have enough money to contribute, but that’s another topic).
So, let’s break down the basics of IRAs. Note that this article is only an introduction to how IRAs work. It’s meant to give you an understanding of what’s out there, but you’ll need to do more research or get advice from financial professionals if you really want to use these accounts.
What is an IRA?
An IRA is a type of account you use to save for retirement. IRAs have certain tax “features” or benefits that are not found in plain-old bank accounts or in plain old taxable brokerage (and mutual fund) accounts.
If an account is an IRA, it simply means that these tax features exist. It does not mean that you have to use any specific type of investment, although the universe of investments available in IRA accounts is smaller. Think of an IRA as a “tax force-field” around your money. In very general terms, the IRS will not break that force field and tax you on the things that happen in that account. If you earn dividends, capital gains, or interest on bank deposits, that income should not be counted as part of your taxable income. Will those gains and income ever be taxed? It depends, partly on what type of IRA you use and partly on when you pull the money out.
Two Flavors
There are two types of IRA accounts: Traditional IRAs and Roth IRAs. Traditional IRAs are generally considered pre-tax IRAs. That is, you may be able to put money into the account “before taxes,” or to get a deduction on your contribution to the account. That’s a nice feature that helps reduce the income you report to the IRS, which therefore can reduce the amount of taxes you pay. However, not everybody gets to take a deduction. Depending on your income (including your spouse, if any) and workplace benefits, you might not qualify for the deduction. You can get a ton of information on this topic from www.irs.gov.
If the money isn’t taxed today, will it be taxed tomorrow? You bet. Uncle Sam needs his cut eventually, so you’ll be taxed on everything you pull out of the account in retirement. It’s as if every penny you withdraw is income that you earned, and you’ll have to declare it as such on your tax returns. But, you get a little help saving the money as it goes in, and all of the growth in the account is “tax-deferred” (in other words, you get to keep all of the earnings in the account – and reinvest them for even more earnings – and wait until withdrawal time to pay taxes).
The second type of IRA is the Roth IRA. This is often called a post-tax IRA because you don’t get any tax benefit in the current year when you make contributions. However, you won’t have to pay taxes on any of the money you withdraw in retirement – as long as you follow all of the IRS rules (such as waiting until age 59.5, and keeping the money in a Roth for at least 5 years). So, you get the taxes out of the way today. That might be appealing if you think you’ll pay taxes at a higher rate when you’re in your retirement years.
Anybody can contribute to a Traditional IRA (although you might not get to deduct your full contribution), but some people aren’t allowed to contribute to a Roth IRA. If you make too much money, you may be out of luck (nice problem to have, really). You might still be able to contribute to Roth 401(k) at your workplace, though, assuming your employer offers it.
You can generally contribute up to $5,000 of your earned income to an IRA, but if you’re over 50 years old you can contribute an extra $1,000 (that’s in 2013, but these numbers change from time to time). Again, your income and other factors might reduce or eliminate the amount you’re allowed to contribute.
Early Withdrawal?
IRAs are designed to help you save for retirement. That might be a long way away. What happens if you pull the money out early (by early, let’s go with: before the age of 59.5, which is the simplest way of saying when the IRS wants to let you take it out). If you have a Traditional IRA, you’ll have to pay income taxes on the amount you withdraw, and you may have to pay an additional 10% penalty tax on that amount (some exceptions apply, talk with the IRS for details). If you have a Roth IRA, you can often pull out your contributions without taxes at any time – but you will have to pay taxes and/or penalties on any earnings that you withdraw.
As you can see, an IRA is not a savings account. It’s for money that you don’t intend to spend until retirement, whether that’s a long ways off or just a few years away.
Yes, This is Important
Now, all of this information is just an overview. You should be sure that you understand whatever type of investment you intend to use in your IRA and how it’ll be treated by the IRS. More sophisticated investments make things more complicated, for example. Always have a seasoned tax preparer review your strategy before you take action (or decide not to take action). In addition, there are a million twists and exceptions to the rules discussed above, but those are beyond the scope of this article. Talk with a tax expert before you take any action with your money, as they may be able to share some valuable ideas. You have to follow IRS rules to use an IRA successfully (this is not difficult for most long-term savers, but it helps to make yourself aware of those rules ahead of time).