It’s St. Patrick’s Day. The forecast is for snow. That must mean spring—and tax deadlines—are just around the corner. It’s a good time to think about IRAs.
These individual retirement accounts are an attractive option for anyone beginning to save for retirement, especially those who don’t have access to 401(k) or other retirement plans through their work. It’s not too late to set up an IRA for 2007; the deadline is April 15. The maximum contribution for an individual for 2007 is $4000 per year, or $5000 for those 50 and older. For 2008, those amounts increase to $5000 and $6000.
An IRA is only available for those with earned income. Parents couldn’t open IRAs for their children, for example, unless the kids had earned at least as much income as the amount of the contribution to the IRA. Spouses can open separate IRAs, however, even if only one of them has earned income.
The two most commonly used types of IRAs are the traditional and the Roth. In the traditional one, your contribution is tax-deductible. The trade-off is that you pay taxes on the amounts you eventually withdraw. If you withdraw any of the money early, you’ll pay a 10% penalty in addition to the taxes. Under some circumstances, such as the contributor’s death or disability, the penalty does not apply.
Your contributions to a Roth IRA are not tax-deductible, but you don’t pay taxes when you withdraw the money. For younger people, the Roth is usually the way to go. Even though you don’t get the immediate tax deduction, you will come out ahead in the long run because you won’t pay taxes on what you withdraw.
One important point to clarify is that an IRA, in and of itself, is not an investment. It’s just a type of account that holds investments. You might think of the IRA as a container; the investment is the contents of that container.
When you open an IRA, all you do initially is deposit your money. Then you need to decide how to invest that money. You generally can buy stocks or mutual funds, depending on the choices offered by the company managing your IRA. As always, my recommendation is to go with mutual funds that are as diversified as possible.
There are many companies that can set up IRAs. These include banks and credit unions, online discount brokers, and insurance companies. It’s important to keep in mind that many of these institutions have limited choices for your IRA investments. In addition, the people you talk to may be salespersons whose income is based on commissions on whatever funds they sell you. That doesn’t mean such an IRA is a bad choice; it just means you want to be cautious and ask plenty of questions.
One of my pet peeves is so-called “financial advisors” who sell people variable annuities for their IRAs. This makes no sense—except to the salesperson who gets a commission from the transaction. Like an IRA, an annuity is a tax-deferred container to put investments in. Since your IRA investment is already tax-deferred, it makes no sense to put another tax-deferred investment inside it—especially since fees for annuities are high because you’re paying for insurance protection.
Before opening an IRA, it’s wise to do some research and educate yourself as much as you can. A good place to start is the Internet; go to www.irs.gov and search for IRAs. Many companies that offer IRAs also have basic information on their websites.
There are risks with IRAs, just as there are with any investments. Still, they are one of the best possible ways to begin building a retirement nest egg.