1. Money
You can opt-out at any time. Please refer to our privacy policy for contact information.

How IRAs Work

Some Pros and Cons

By

When retirement rolls around, how are you going to pay for food, gas, housing, and more? A lot of people haven’t yet thought this out: when you retire, you probably stop receiving a paycheck. Although some organizations pay a retirement pension, these types of retirement plans are becoming less common. As a result, we’re forced to take retirement saving into our own hands.

Overview of IRA’s

For many, an Individual Retirement Account (IRA) is a good option for saving. An IRA is an account type that has certain tax characteristics. Because the US government wants us to save for retirement, we enjoy certain tax advantages within an IRA. However, there can be penalties if you don’t use an IRA for its intended purpose.

Tax Advantages of IRA’s

The main benefit is that investments in IRA’s grow tax-deferred. This means that earnings are not taxed each year – they’re reinvested for more growth. This keeps your investments working harder and allows your money to compound.

Another potential benefit is the ability to deduct contributions from your taxable income. This allows you to pay taxes on less money in the current year, even though you saved it and have it as an asset. Not all IRA’s have this feature, and not every taxpayer can enjoy this benefit, but it can be helpful for some.

Pitfalls of IRA’s

If you think that the IRS is giving you a great deal, you’re right. However, as with all things in life, there are tradeoffs.

IRA’s are intended for your retirement savings. This means that the IRS does not want you to take the money out until you reach “retirement age” – as determined by the IRS (this is age 59.5 in 2005). If you take your assets out of an IRA before that age, you may have to pay a 10% penalty on the amount you withdraw. You may have to pay income tax on that amount as well – this can add up!

Another pitfall is that there are limits on how much you can contribute to an IRA. It could get awfully expensive (in terms of lost revenue) for the IRS if you put all your money away and didn’t pay taxes on it. Therefore, you’re limited to contributing a certain portion of your earned income – and not a penny more! Because these limits change yearly, I suggest you head over to IRS.gov and search for “Publication 590” for all the details, rules, and regulations.

If it turns out that you need to get money out of an IRA before the IRS-defined retirement age, you should check to see if you qualify for any exceptions to the 10% penalty. A good CPA should be able to help you with this.

Investments Within IRA’s

A lot of bank customers think that you can only invest in CD’s within an IRA. In fact, there are other options with greater risk/reward characteristics.

If you are willing and able to accept the additional risks, you can invest your IRA money in mutual funds or stocks. Especially for those who have more time until they pull their money out of an IRA, mutual funds can be a good choice.

While CD’s are safe, they tend to have lower long-term returns than riskier investments – which means you’re taking a risk that inflation could erode your returns. Just ask an elder how much things used to cost when they were young to get an idea of inflation’s effects.

If you’re considering investing in stocks or mutual funds, you have to know what you’re getting into. In particular, consider the risk that you might lose money! If you are unsure of the proper way to proceed, you can always ask for help from a licensed financial advisor. Before you invest with anybody, make sure they are honest and reputable.

Justin Pritchard is a Registered Representative and Investment Advisor Representative of Financial Network Investment Corporation, Member SIPC.

  1. About.com
  2. Money
  3. Banking / Loans
  4. Investments
  5. Overview of IRAs (Individual Retirement Account)

©2014 About.com. All rights reserved.