IRA is a term that is thrown around constantly in the world of personal finance, but they are not well understood by most Americans. IRA stands for Individual Retirement Account, and is intended to be a savings vehicle in the U.S. that encourages people to save money for retirement that will be supplemented by Social Security and other savings.
History: IRAs were created in 1974 with a piece of legislation called ERISA (the Employee Retirement Income Security Act). Prior to ERISA, most retirees lived on savings, Social Security, and a pension that was provided by their employer or a union. However, many of these pensions were poorly managed or stolen from by their administrators, leaving workers without the money they had spent their careers earning. Congress opened an investigation, and determined that giving workers an incentivized new way to save for retirement would be beneficial. IRAs have been in existence since their creation, and Congress has slowly improved their benefit over time.
Explanation: An IRA is a special account that you can set up with a broker, bank, or other financial institution that is tied to an individual. The money that you put into an IRA will give you some kind of a tax-benefit, based on the type of contribution you make (more on that later). You have a set limit of money that can be contributed to an IRA for a given tax year, which is set by Congress as laws are updated. For 2019, the most you can contribute to an IRA is $6,000. Because this money is intended for retirement, Congress wanted to encourage us to keep the money in until our twilight years. As such, there is a penalty for taking money out before the age of 59½. Yes, it’s fifty nine and a half years old. Yes, that is a strangely arbitrary age. There are a few exceptions to the withdrawal penalty, but it is generally best to leave that money alone.
Money can be contributed to an IRA in one of two possible ways. You can either make “Traditional” or “Roth” contributions, which are treated differently for tax purposes. A traditional contribution is considered pre-tax, meaning that any money you contribute is not taxed for the year you put it in. For example, if you made $50,000 in a year and had traditional contributions of $6,000, you would only pay income tax on $44,000 for the year. However, you will be taxed on your withdrawals and their growth in retirement. Roth contributions are the exact opposite, and are considered to be post-tax. That means that you will pay income tax on the contributions in the year you make them, but you aren’t taxed on the contributions or their growth when you withdraw them in retirement.
Having two different methods is extremely useful for financial planning. Because you can make traditional and Roth contributions in any combination for a tax year (though the sum of the contributions cannot exceed the annual limit), you can optimize for tax planning, while simultaneously saving for retirement. Based on your current situation and your future goals, it is possible to save tremendous amounts on income tax as you grow older. Also, because the money can be invested, the principal that you contribute can multiply to a much larger number thanks to the power of compound interest.
Action: If you don’t have an IRA set up, you need to do so. It is extremely easy to do, and takes very little time. Once you have an IRA set up, you should set up automatic contributions, which come out of your paycheck without any action on your part. For many people, it is best that you work to max out your annual IRA contributions as soon as you can. The money will add up quickly, and you don’t want to leave that tax benefit behind in any year. If you don’t know how to invest or what to invest in, talk to a fiduciary financial planner that you trust.
The sooner you set up an IRA and start funding it, the more security you will have for retirement!
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