As the April 15 tax deadline approaches, you may start to see more and more ads for IRAs on TV, online and in the mail this time of year. If you're in need of a quick refresher, here's a crash course on the ins and outs of these individual retirement accounts, which, if used effectively, will help you retire comfortably and in good financial health.
What is an IRA?\nIRA stands for individual retirement account, a special type of tax-favored account that exists because the government wants to encourage citizens to save money for retirement. IRAs are distinct from many more familiar retirement accounts because you set them up and contribute to them on your own instead of through your employer. Common types of retirement accounts that your job may provide to you include a 401(k) or 403(b) account.
How an IRA benefits you\nThe most important benefit of IRAs is that they can be used to reduce the amount of taxes you have to pay, leaving more money in your pocket. There are many ways that IRAs can lower your taxes. They can reduce your taxable income today, for the year that you contribute (put money into your account) or when you retire and withdraw (take money out) from your IRA. Additionally, they provide the benefit of allowing money in the account to grow without you having to pay taxes on investment appreciation (growth) each year. Normally, you have to pay taxes every year on realized investment gains - interest, dividends, capital gains, etc. - but you don't have to if your investment gains are in an IRA.\nAnother important benefit of an IRA is that it is a simple and effective vehicle to save for retirement. You can use an IRA to save for retirement without having to spend too much time and energy thinking and planning. You can even set an IRA on autopilot for contributions (direct deposit) and/or investing (with a target date retirement fund). Spending a small amount of time today can set yourself up much better for the future.
Eligibility for an IRA\nTo be eligible to contribute to an IRA, you must have earned income - from working, not from investments - through a full-time or part-time job. Whether teaching, driving a UTS bus, doing research, flipping burgers or restocking shelves, it doesn't matter what you do, as long as you were working and receiving a pay check.\nThe maximum yearly contribution for IRAs is $5,000, but people older than 50 can contribute up to $6,000. That figure, however, is restricted by earnings. If your salary was less than $5,000, then you only can contribute the amount you earned.
Traditional IRA versus Roth IRA\nThe two main types of IRAs are the traditional IRA and the Roth IRA. The basic difference is when you can save on taxes. A traditional IRA typically lets you take a deduction when you contribute, reducing your taxes that year. Then the money can grow tax-free for many years. When you retire and start taking the money out, then you will pay taxes on it.\nA Roth IRA is like the reverse. The money goes in after-tax (no deduction), and the growth each year still will be tax-free. Then when you retire and withdraw the money according to the plan rules, you will not have to pay taxes on it. As a result, you never have to pay taxes on the investment growth that accrues while the money is in the account.\nFactors to consider when deciding between a traditional IRA and a Roth IRA include your expectations for tax rates and your eligibility. For example, if you expect to earn less money in retirement and foresee your salary placing you in a lower tax bracket, then a traditional IRA may make more sense. But many students who typically have lower incomes while in school benefit most from a Roth IRA since they will face higher tax brackets in the future and won't have to pay taxes on the interest they receive when they withdraw the funds.
What goes in your IRA\nFor starters, your contribution goes in, but then you need to decide how to invest that money. Think of an IRA as a package or wrapper for investments. Inside can be a bank account, stock portfolio, bonds, etc. By having your investments inside the IRA "wrapper" you get the tax benefits.\nSo assume you contribute the maximum $5,000. Now you need to decide what investments to buy with that money. You could use an IRA to invest in stocks, bonds, real estate, commodities, and more. Since most people opening an IRA are many years from retirement, long-term investments like stocks are probably a very good way to go. If you are a less involved investor, then mutual funds might be the best option.
Opening an IRA\nYou can open an IRA through a bank, mutual fund or brokerage company. Many companies will let you start opening an IRA online, although you can also do it over the phone, in person and by mail. You should make sure that the company offers investment choices that fit your needs (see above). If you are a savvy and experienced investor, then you probably will have no difficulty figuring it out. Just remember to shop around for lower fees and be sure that the minimum investment works for you. If you are a less experienced investor, then mutual funds are probably the easiest way to go. I advised my sister - who is not particularly interested in investing or knowledgeable about it - to go with Vanguard , a mutual fund company, and a target date retirement fund for her investments. These funds use your estimated retirement date to change the mix of investments, reducing risk (and return) as you get closer to retirement. Because my sister was born in 1982, she chose the 2045 fund, which is closest to when she turns 65.
Take action before April 15\nThe reason why you see all the extra advertising this time of year is because you still can make a contribution for last year, as long as you do it by the tax filing deadline. If you have a tax refund, an IRA can be a great way to invest it. The IRS even offers an extra tax credit for low-income people who contribute to an IRA. In other words, the government is giving you extra money if you contribute! If you file as a single person and make less than $26,500, then you may be eligible. (Married and head of household filers can earn more and still be eligible.) Check IRS Form 8880 for details.
Editor's Note: Benjamin Grosz is founder and principal of Grosz Financial Planning, LLC and is a candidate for CFP Board's certification.
Ben's column runs biweekly Thursdays. He can be reached at b.grosz@cavalierdaily.com.
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