We should all be thinking about our retirement. It’s going to happen to all of us sooner or later, and by the time it does, if you haven’t prepared yourself financially, you’re going to be in big trouble. Whether you’re thirty years old, forty, even fifty, it’s never too late to start putting aside for your retirement. The IRA, Individual Retirement Account, is your vehicle for saving for retirement.
Advantages of the IRA
In the old days, before the IRA, when you put money away for your retirement, most likely in a savings account or investment in a secure investment like bonds or even utilities, your retirement fund was very slow growing. But when the IRA was created, allowing you to put your money into a fund, one that can be invested in thousands of different funds itself, everything changed. But the biggest change of all: you were now allowed to put money away in your very own IRA TAX FREE. That’s right. Money you now socked away for your retirement could now be deducted from your current taxes. Not only did this spur investment into retirement accounts, because the money was not being taxed, it began growing on interest like never before. But what are the particulars of an IRA? What can be deducted? How much can be deducted? Because IRAs follow most regular IRS tax law, it’s not really that hard to navigate.
Quite simply, the money you are transferring into your traditional IRA, let’s say, is not taxed now because it is going to be taxed at the time you eventually withdraw it. The dollar limit for contributions into your IRA in 2011 are: $5000 for those 49 years old and younger, $6000 for those 50 years and older. Now the catch: to be eligible to contribute money into an IRA, you must have earned income. The IRA requires that retirement money be invested from earned money. This is money that is earned and reported on the IRS standard form W-2. This can be income earned as self-employed, a farmer, or even alimony. You cannot be older than 70.5 years old to contribute to an IRA.
So, how much of your contribution to your IRA is tax deductible? Well, up to the limit per year, all of it. But it isn’t quite that simple. In some cases, it depends. There are different rules for the Roth IRA and the traditional IRA. For one thing, you are not allowed to contribute more to your IRA (tax free) than you earned in income that same year. This means you cannot make $100,000 in one year, and in that same year attempt to dodge taxes on a higher level, say one million dollars. There is no carryover of taxable compensation for your IRA.
Facts about your IRA deductions – with an employer-provided retirement plan
Here is an example. In the year 2001, if you were covered let’s say by a retirement plan supplied by your employer, heads of household can deduct 100% of their IRA contribution if their AGI, Adjusted Gross Income, is $56,000 per year or less. Up to $66,000 a year, you may get a partial deduction. If you make $66,000 per year or more, then the deduction is completely phased out.
For a household of two, for married couples filing jointly (as well as widows and widowers), the law is clear that they are allowed to take a full deduction up to $90,000 per year in income. This same deduction is no longer valid after an annual income of $110,000.
Facts about your IRA deductions – without an employer-provided retirement plan
For those not provided with a retirement plan at their place of employment, the limits for personal tax deductions on your IRA become more favorable. (You must remember, even though retirement contributions made in your name by your employer are not considered income at the time and not taxed in the same year you receive them, they are in the end a benefit, and therefore must be taken into account against any tax issues pertaining to your personal retirement plan, your IRA). In short, if you’re getting contributions toward your retirement in one place, the IRS is not going to allow you full tax deductions in another. That would amount to something like double deductions.
So, if you do not have a retirement plan at work, one provided to you by your employer, the limits of your tax deductible contributions will be greater. Single tax payers and heads of households, as well as widows and widowers, can deduct the full amount of their IRA contribution, no matter what their income levels were in that same fiscal year. The same goes for married couples, just as long as neither are covered by a retirement plan at their place of employment. This means the tax payers can have an income as high as $179,000 per year until their deductions become phased out.
Differences between your Roth and your traditional IRA, and tax consequences
The one very big difference between your traditional and your Roth IRAs are that with the traditional IRA your contributions are tax deductible at the time of donation. You get tax deductions on the money you put into your traditional IRA, but you pay taxes on the money that you take out. With the Roth IRA, the money you contribute has already been taxed, so there are no tax benefits on the front end. It’s the backend, when you withdraw the money, where you get your tax benefit. There are no taxes applied when you withdraw money from your Roth IRA. Imagine tax rates go up in the thirty years since your money went into your Roth IRA. Does not affect you. With your Roth IRA, you know the money that’s in your account is the money you get out of your account.
Think about your retirement and your levels of income. Most people when they retire, their income goes down. In this case, it seems better to pay the taxes on the backend, when you withdraw the money. For this, the traditional IRA is the better choice for you. Because you are earning less, you will be in a lower tax bracket. The amount you pay in taxes will be lower both in dollar amounts and percentage-wise. As well, by using the deductions provided by your traditional IRA, you can also lower your tax rates during the years of making contributions.
So which is the better way to go?
IRAs are great vehicles for diversifying your taxes in your years of retirement. Because of tax consequences, if you have both a 401K set up at your place of employment as well as any other tax-deferred retirement plan like a pension, the Roth seems to be the best way to go. When retirement comes, when your income levels are lower, it may just be the better idea to have that IRA that you don’t have to dig into your pocket for, that’s already paid off in full.
It really depends on your own personal situation. There are many factors to consider, but either way, an IRA is the way to go when it comes to financing your retirement. The tax benefits are undeniable.