Overview of IRAs
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 dont use an IRA for its intended purpose.
Tax Advantages of IRAs
The main benefit is that investments in IRAs grow tax-deferred. This means that earnings are not taxed each year theyre 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 IRAs have this feature, and not every taxpayer can enjoy this benefit, but it can be helpful for some.
Pitfalls of IRAs
If you think that the IRS is giving you a great deal, youre right. However, as with all things in life, there are tradeoffs.
IRAs 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 didnt pay taxes on it. Therefore, youre 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 IRAs
A lot of bank customers think that you can only invest in CDs 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 CDs are safe, they tend to have lower long-term returns than riskier investments which means youre 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 inflations effects.
If youre considering investing in stocks or mutual funds, you have to know what youre 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.