A classic description of retirement funding is that it is like a three-legged stool, but with at least one of those legs getting a little wobbly these days, you may want to lean particularly heavily on an Individual Retirement Arrangement, more commonly known as an IRA.
Three legs of retirement funding
Those three legs of retirement funding are:
- Social Security
- Employer-sponsored plans such as 401(k) plans
- Personal savings
The Social Security leg has been quite wobbly lately, especially for younger savers, because of uncertainty over its future funding. Meanwhile, since 401(k) plans rely heavily on deferrals out of the employee's own income, the employer-sponsored leg is looking more and more like the personal savings leg, at least for private-sector employees.
Therefore, with so much importance placed on personal savings as the support for retirement funding, it is vital that you seriously consider whether an IRA could help your personal savings. Note that there are traditional IRAs and Roth IRAs; this article will focus primarily on traditional IRAs.
Key rules for traditional IRAs
An IRA is a retirement plan that qualifies for special tax treatment, but in return requires that you follow some specific rules. Here are some of the most prominent ones for traditional IRAs:
- Annual contributions are limited. For 2010, the limits were $5,000 for people under 50, and $6,000 for people aged 50 and over. IRA contribution limits have risen over time, and are likely to continue to do so. These limits apply to any IRA contributions by an individual, so any amount you contribute to a Roth IRA reduces the amount you can contribute to a traditional IRA, and vice versa.
- Contributions are generally tax-deductible. However, limitations on deductibility may apply if you or your spouse are covered by an employee benefit plan, and you have a relatively high income.
- Interest, dividends, and investment gains within the IRA are not taxable. You don't pay taxes on a traditional IRA until you withdraw money from it.
- There is a penalty for early distributions. If you take money out of an IRA before you are aged 59 1/2, unless it is a rollover into another qualified plan, those distributions will be taxed at ordinary income tax rates, in addition to which there will be a 10% tax penalty.
- Withdrawals after you reach age 59 1/2 are taxed at ordinary income rates.
- You have to start making withdrawals after you reach the age of 70 1/2.
Investments for your IRA
Investments in an IRA can range from conservative to aggressive, and can be managed by you or by a professional.
The exact investments you choose should depend on economic conditions, stock valuations, interest rates, and your personal and financial situation. In general, the younger you are, the more aggressive your investments should be, and you should dial back the risk level as you approach retirement.
From a tax standpoint, traditional IRAs basically entail deferring taxes now in favor of paying them after retirement. The assumption generally has been that a person will be in a lower tax bracket in retirement than during the peak years of a career, but this may not always be true.
It's also worth noting that since distributions are taxed at ordinary income rates, you may ultimately pay a higher tax rate on gains within the IRA than you would otherwise. For several years now, tax rates on capital gains have been lower than the ordinary income rates which apply to dividends and interest.
To commit or not commit?
Because of the 10 percent penalty for early distributions, the key question you face in starting a traditional IRA is whether you can commit the money until you reach age 59 1/2. If you feel you can make the commitment, the threat of this penalty is actually helpful to retirement saving -- it helps discourage people from dipping into those savings for immediate expenditures.
Overall, then, a traditional IRA can be a good way to strengthen the critical personal savings leg of the retirement funding stool.
Let GetRichSlowly know about your experience with traditional IRAs. Was the 10 percent penalty a deterrent, and if not, what gave you the confidence to commit your money?