CNN Money: Ultimate guide to retirement - IRAs



CNN Money: Ultimate guide to retirement - IRAs



What is an IRA?

IRA stands for Individual Retirement Account, and it's basically a savings account with big tax breaks, making it an ideal way to sock away cash for your retirement. A lot of people mistakenly think an IRA itself is an investment - but it's just the basket in which you keep stocks, bonds, mutual funds and other assets.

Unlike 401(k)s, which are accounts provided by your company, the most common types of IRAs are accounts that you open on your own. Others can be opened by self-employed individuals and small business owners. There are several different types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.

Unfortunately, not everyone gets to take advantage of them. Each has eligibility restrictions based on your income or employment status. And all have caps on how much you can contribute each year and penalties if you yank out your money before the designated retirement age.

What's the difference between Roth and traditional IRAs?

The main difference is when you pay income taxes on the money you put in the plans. With a traditional IRA, you pay the taxes on the back end - that is, when you withdraw the money in retirement. But, in some cases, you may escape taxes on the front end - when you put the money into the account.

With a Roth IRA, it's the exact opposite. You pay the taxes on the front end, but there are no taxes on the back end. And remember, in both traditional and Roth IRAs, your money grows tax free while it's in the account.

There are other differences too. While almost anyone with earned income can contribute to a traditional IRA, there are income limits for contributing to a Roth IRA. So not everyone can take advantage of them.

Roth IRAs are more flexible if you need to withdraw some of the money early. With a Roth IRA, you can leave the money in for as long as you want, letting it grow and grow as you get older and older. With a traditional IRA, by contrast, you must start withdrawing the money by the time you reach age 70½.

Why is an IRA a good deal?

Because money in the plan grows free from the clutches of Uncle Sam. That is, the income from interest, dividends and capital gains can compound each year without taxes nipping away at it.

In addition, you also can escape taxes on either the money you put into the plan initially or on the money you withdraw in retirement, depending upon whether you choose a traditional or Roth IRA.

So what's the catch? The government limits the amount of money you can put into an IRA each year. Most people under 50 can contribute no more than $5,000 a year; that limit rises if you're older.

Who can put money into an IRA?

It depends on what kind of IRA it is. Almost anyone can contribute to a traditional IRA, provided you (or your spouse) receive taxable income and you are under age 70 ½. But your contributions are tax deductible only if you meet certain qualifications. For more on those qualifications see Who can contribute to a traditional IRA?

Roth IRA contributions are never tax deductible, and you must meet certain income requirements in order to make contributions. For 2010, your modified adjusted gross income must be $167,000 or less if you are married and filing jointly; $105,000 or less if you are single, head of household or married filing separately (and didn't live with your spouse at any point during the year); $10,000 or less if you are married, filing separately and lived with your spouse for any part of the year. Those who make slightly above these limits may still be able to make partial contributions. For more see Who can contribute to a Roth IRA?

SIMPLE and SEP IRAs are for self-employed individuals or small business owners. To set up a SIMPLE IRA an employer must have 100 or fewer employees earning more than $5,000 each. And the employer cannot have any other retirement plan besides the SIMPLE IRA. Any business owner or individual with freelance income can open a SEP IRA.

How much should I put into an IRA?

It's generally a good idea to put as much in an IRA as the government allows you to. That's because the more you save in a tax-favored account, the more tax-protected gains you can rack up.

If you're younger than 50, your 2010 contributions to a traditional IRA or a Roth IRA are limited to $5,000 or the total of your taxable compensation, whichever is smaller. If you're 50 or over before the end of the year, you're allowed to contribute up to an additional $1,000 for a total yearly contribution of $6,000; this is the IRS's way of encouraging you to save more in the final years before retirement.

However, the amount you can contribute to a Roth IRA also depends on your income. To make the full contribution, your modified adjusted gross income must be less than $105,000 if you're single, or $167,000 as a married couple filing jointly. If you earn slightly above those amounts, you may be able to make smaller contributions, which phase out after $120,000 and $177,000, respectively.

When can I access money in my IRA?

You can take money out of an IRA whenever you want, but be warned: if you're under age 59 ½, it could cost you. That's because the government wants to discourage you from raiding your IRA until you're retired. (It's a retirement account, after all.)

If you are under 59 ½: If you withdraw any money from a traditional IRA, you'll be slapped with a 10% penalty on the amount you withdraw. That's in addition to the regular income tax you'll owe on your withdrawal. Bad idea.

Roth IRAs offer a bit more flexibility. Generally, you may withdraw your contributions to a Roth penalty-free at any time for any reason, as long as you don't withdraw any earnings on your investments (as opposed to the amount you put in) or dollars converted from a traditional IRA before age 59 ½. In that case, you'll get hit with that same 10% penalty. Not sure which money is considered a contribution and which is considered earnings? The IRS views withdrawals from a Roth IRA in the following order: your contributions, money converted from traditional IRAs and then earnings. So if you take out more than you've contributed in total, then you're starting to dip into conversion dollars or earnings, and will be penalized and taxed accordingly.

If you're 59 ½ or older: You can usually make penalty-free withdrawals (known as "qualified distributions") from any IRA. But you'll still owe the income tax if it's a traditional IRA. To make qualified distributions from a Roth IRA, you must be at least 59½ and it must be at least five years since you first began contributing. And if you converted a regular IRA to a Roth IRA, you can't take out the money penalty-free until at least five years after the conversion.

When are IRA withdrawals penalty-free?

If you're 59 ½ or older you're usually all clear. But if you're younger than that, you will get hit with a penalty for early withdrawals from traditional IRAs, or early withdrawals on earnings from Roth IRAs.

But you can escape that 10% tax penalty if you're withdrawing the money for a few specific reasons.

These include:

Paying college expenses for you, your spouse, your children or grandchildren.

Paying medical expenses greater than 7.5% of your adjusted gross income.

Paying for a first-time home purchase (up to $10,000).

Paying for the costs of a sudden disability.

Also, if you put money into your IRA but then decide you need it back, you can generally "take back" one contribution made to a traditional IRA without paying tax, as long as you do it before the tax filing deadline of that year and do not deduct the contribution from your taxes.

You can also withdraw money from a traditional IRA and avoid paying the 10% penalty if you roll the money over into another qualified retirement account (such as a Roth IRA) within 60 days. But then you wouldn't actually be able to spend it.

Are you really that desperate for cash? Well, if so, it is possible to take money out of your traditional IRA in what's called "substantially equal periodic payments." Here's how it works: The IRS will determine what amount you can receive each year based on your life expectancy. That's the amount you must withdraw each year.

Sound too good to be true? The method is certainly not without risks. Once you start substantially equal periodic payments, you can't stop the payments until you're 59½ or five years have passed, whichever is longer. So there's no changing your mind. If you change or stop these withdrawals at any time, you'll get hit with that 10% penalty - applied retroactively from the time you first began receiving payments. So it's generally not a great idea if you're under 50. Even if you are over 50, you'll be eating away at your retirement nest egg, rather than building it up. That means you're likely to come up short when you actually do retire.

When do I have to start taking the money out of an IRA?

If you have a traditional IRA, you must take required minimum distributions starting in the year you turn 70 ½. The amount of the distribution depends on how much you have saved in the account and on your life expectancy, according to tables published by the IRS. If you own a Roth, you can leave the money in for as long as you want.

What if I need the money in my IRA before retirement?

If you withdraw money from a traditional IRA before you turn 59 ½, you must pay a 10% tax penalty (with a few exceptions). The same rule applies if you withdraw investment earnings from a Roth IRA. The exceptions involve cases in which you use the withdrawal to pay for college expenses, to buy your first home (up to $10,000) or for medical expenses greater than 7.5% of your AGI (adjusted gross income), or in case of disability.

How should I invest the money?

The IRS dictates a few ways in which you can't use the money in your IRA, including lending money to yourself, using it as collateral for a loan and buying real estate for your personal use. Beyond those exceptions, you can invest in just about anything: mutual funds, individual stocks and bonds, annuities and even certain real estate.

It's a good idea to diversify your assets among stocks, bonds and cash. Stocks can provide long-term growth potential, while bonds and cash offer some protection against market setbacks. The allocation that's right for you comes down to how long you'll have your money invested and what sort of short-term ups and downs you're willing to accept in the value of your portfolio. The longer your investment horizon, the more it makes sense to invest in stocks. But if you can't stomach occasional market downturns, you might want to hold a larger share of bonds.

How do my IRA withdrawals get taxed in retirement?

Your withdrawals from a Roth IRA are tax free as long as you are 59 ½ or older and your account is at least five years old. Withdrawals from traditional IRAs are taxed as regular income, based on your tax bracket for the year in which you make the withdrawal.

Where should I open an IRA?

You can open an IRA through almost any large financial institution, including banks, mutual fund companies and brokerage firms. Most IRA providers offer a broad variety of investment options, ranging from CDs to money market funds to mutual funds to individual stocks and bonds, so you can put together a diversified retirement portfolio within your IRA no matter which one you choose.

The major difference between most institutions is the fee structure. So make sure to carefully compare fees before choosing where to open your IRA.

Should I take money from my IRA to pay off debt?

Taking withdrawals from an IRA before you're retired is something you should do only as a last resort. There are a few reasons why.

If you withdraw money from a traditional IRA before you turn 59 ½, you must pay a 10% tax penalty (with a few exceptions), in addition to regular income taxes. Plus, the IRA withdrawal would be taxed as regular income, and could possibly propel you into a higher tax bracket, costing you even more.

Though the feds allow you to withdraw contributions from a Roth IRA without incurring a penalty, you will owe a penalty (and taxes) if you withdraw the earnings on those contributions.

In addition, money you take out of an IRA cannot be replaced, since you would still be restricted to yearly contribution limits for future contributions. So even if you withdraw only a small amount, factor in the years of compounding interest you would be forgoing, and that small withdrawal could end up costing you a small fortune in your golden years.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download