The first of a series of articles addressing how an individual may save in various types of retirement accounts.
This article addresses traditional IRAs to which an individual contributes directly. These are not employer-based plans, though there are some issues with employer-based plans which do affect these, either in how much one may deduct, or in some cases, an IRA to which both an individual and his employer may add funds. For some discussions about employer-based plans, both for regular employees and for the self-employed (which includes partners in partnerships), come back soon and look for future articles in this series.
The first thing to clear up is the common misconception that "IRA" stands for "Individual Retirement Account." It's used that way, but technically, it's really "Individual Retirement Arrangement." And therefore, your IRA may encompass multiple IRA accounts, including potentially, savings accounts, CDs, brokerage accounts, mutual fund accounts, annuities, and even a "self-directed" IRA account at a custodian/trustee which may be used to buy things one normally couldn't buy in a traditional brokerage account such as securities which don't trade on regular markets, investment real estate, etc.
An individual, therefore, has only one IRA, but that IRA may have multiple pieces distributed among, effectively, multiple dimensions - different kinds of accounts (mutual fund, brokerage, annuity, etc) and each of these different kinds of accounts may be either "traditional" or "Roth." Roth accounts will be addressed in more detail in a future article.
IRAs are always associated with a single individual. There is no such thing as a joint IRA. A married couple may have two IRAs, one belonging to each spouse. Typically, one makes one's spouse the designated beneficiary who will receive the IRA account (and beneficiary designations are typically on an account-by-account basis) in the event of the first spouse's death. And there are a variety of other issues relating to how an inherited IRA may be handled, which are beyond the scope of this article. But for now, the important thing to note is that an IRA is an individual retirement arrangement.
Another misconception about IRAs is about who may contribute to one. When traditional IRAs were first created in 1974, anyone with earned income could contribute (up to $1500/yr) and deduct their contributions from their income tax, but they could only contribute to them if they were not covered by an employer-based qualified plan (like a profit-sharing plan or a defined-benefit plan).
In 1981, the pool of people permitted to contribute to IRAs was expanded to include people covered by qualified plans at work. Effectively, at this point, anyone with earned income could contribute. (Plus spouses of people with earned income could contribute as well).
And in 1986, it got messy. Everyone with earned income (plus spouses) could still contribute to an IRA, but those covered by employer-based qualified plans were now no longer allowed to deduct their contributions from their income for tax purposes. That means that an IRA funded with non-deductible contributions had a mix of money - some which was "after-tax" and some of which was "pre-tax". This is still the case. When one makes non-deductible contributions to an IRA, the IRA has "basis" and this affects how much is going to be taxed when the money ultimately comes out. An example below will show how this works in more detail.
Example: Bob makes a $5000 non-deductible contribution to a traditional IRA. Over time, that IRA grows to $7500. Bob, now assumed to be over the retirement age and permitted to take distributions without penalty, takes a $1500 distribution from the IRA. The amount of that distribution which is taxable is computed based on the proportion of the account balance which was after-tax ("basis") versus the total balance. In this case, the account has a $5000 basis and a value of $7500, so 2/3 of the value of any distribution is effectively a return of that basis and non-taxable. So even though Bob took a $1500 distribution, he owes income taxes only $500 of it and his basis for the rest of the IRA is reduced by $1000.
Note that basis in your IRA is tracked by you. If you make non-deductible contributions to a traditional IRA you must make sure to file a form 8606 with your taxes. You may find the blank form here: www.irs.gov/pub/irs-pdf/f8606.pdf
Your accountant or tax-prep software should ask you about IRA contributions and employer-based retirement plans and determine the deductibility and fill out the 8606 form for you. But it is your responsibility, so don't forget to do this! If you don't file the 8606, but you also don't deduct the contributions, you'll pay taxes twice on the same money.
Why bother with IRAs? It's "tax-deferred" investing. The growth of the money (whether the contributions were deductible or not) is not taxed each year along the way, but instead, only taxed when the money is distributed. Tax-deferred compounding can have an enormous impact on the growth and, ultimately, how much you'll be able to spend from it.
Here's an example with some numbers, though please note that individual circumstances are always going to be quite different from this. Suppose Bill's income is such that he's in the 25% tax bracket. That means that, at the margin, if he just takes and spends it, the next $1000 he earns will be taxed at 25%, so of that $1000, he'll pay $250 in income taxes and get to spend or invest $750.
Now suppose he invests that $750 in a portfolio of bonds which earns 4%/year. (I use bonds for this example for simplicity and to demonstrate the tax issues - note that the tax issues for stocks and funds with qualified dividends and various forms of capital gains make the issue more complex than this.) So after a year, that $750 has earned $30. Unfortunately for Bill, he can't keep all $30 that his investment earned. His marginal tax rate is 25%, so of that $30, he's got to pay $7.50 in income taxes, leaving him only $22.50 to re-invest into his portfolio or to spend. His portfolio, assuming he doesn't spend the money, is now worth $772.50. His after-tax return was only 3% rather than 4%. In a single year, this may not be a big deal, but over many years, the difference compounds exponentially. It's huge. If he lets this $750 grow at 4% but pays 25% income taxes on the growth each year for 20 years, at the end, he's got $1,354.58 to spend.
Suppose instead of investing after-tax like that, Bill takes that $1000 he's earned and puts it into a tax-deductible IRA. Inside the IRA, he invests it exactly the same way - in that exact same bond portfolio earning 4% per year. After the first year, the portfolio earned $40 and the portfolio is now worth $1040. If he were to spend it now (ignoring early-distribution fees and only looking at tax impact), he's got to pay 25% income taxes on the full $1040 -- leaving him, after one year, assuming he's distributing the whole thing to a taxable account and possibly spending it, $780 to spend.
Now let's have Bill put that $1000 into the IRA and leave it there, compounding at 4%/year, for 20 years. Before taxes, the $1000 grows to $2191, which is a *lot* more than the $1,354 he got by investing after-tax. But he doesn't get to spend all of that $2191 since it's all still "before-tax" money inside the IRA. If he liquidates the IRA and distributes it out so that he may spend it, he'll have to pay income taxes on the whole amount. After removing the 25% taxes, he's got $1,643 to spend. In other words, on a fully after-tax, available-to-spend basis, by putting the money into the IRA instead of a taxable account, and investing it identically, he's come out ahead by $289. Considering the original investment was only $1000 (or $750, really), that's an enormous difference. And the difference is even bigger after more time, or with a higher-yielding investment, or at a higher tax rate.
For many folks, especially at high marginal tax rates (ie. during their peak earning years) and for whom retirement will be a good ways into the future, saving for retirement via an IRA may be a very attractive prospect.
So who may invest in an IRA? Anyone with earned income, or the spouse of anyone with earned income.
How much may they invest in an IRA? the lesser of $5000 or their earned income. One may make an IRA contribution for a given tax year as late as when one files one's taxes for the year. So for 2011, one may open an IRA account (if one doesn't already have one) and make an IRA contribution as late as April 17, 2012. Moreover, if one is age 60 or greater, there's a "catch-up" provision which raises the maximum up to $6000. Contributions may not be made to a traditional IRA for the year in which one reaches age 70-1/2 (or any later year).
Note that for many people who have a retirement plan at work, and their income is above the threshold, while they may invest in an IRA, they may not be able to deduct it. If Bill, described above, put $750 (after-tax) into an IRA which he didn't deduct, the account grows from $750 to $1,643, but he doesn't get to spend that full $1,643. $750 of that was his basis and the rest, if he takes the distribution, is taxable at his marginal rate. After taxes, he may spend $750 + ($1,643 - $750) * 0.75 = $1,420. It's still substantially better than the fully after-tax amount he'd have had if he'd invested in a taxable account ($1,354), but not as good as a fully deductible IRA.
So what are the downsides? Mainly access to the money. After age 59-1/2, generally, any money in the IRA may be removed and subject only to the income taxes due. Before 59-1/2, there are several other exceptions which allow one to take the money out without penalty (though generally still owing income taxes).
Other issues to be aware of: (a) after age 70-1/2, whether one wants to or not, one must start taking taxable distributions from the IRA, these are called "required minimum distributions" and they are generally based on one's age. (b) if one's estate is subject to estate taxes, the pre-tax value of the IRA may be included in the estate -- which means that one may pay estate taxes on assets some of which are ultimately going to be lost to income taxes as well. (c) certain investments in IRAs are prohibited, such as collectibles or life insurance, or anything from which the investor receives direct benefit (ie. real estate which is owner-occupied) (d) certain investments may cause other tax issues such as double-taxation (which may happen with investments in foreign securities) or UBTI (unrelated business taxable income). Most typical stock and bond mutual funds, however, don't have any of these issues (c) or (d).
Other benefits: assets in the IRA are generally better protected from creditors than are assets held directly in a taxable account; assets in an IRA are generally not included in any college financial-aid calculations; and finally, assets in a traditional IRA may be rolled over (especially beneficial during a low-tax year, say a year of unemployment) into a Roth IRA. Roth IRA accounts will be discussed in a future article.
And one more thing - starting in 2002 (due to 2001 legislation) and made permanent under the Pension Protection Act of 2006 - there is a non-refundable tax credit available to certain folks (mainly those who make moderate or low incomes) who make contributions to certain qualified retirement plans - including traditional IRAs. It's called the Retirement Savings Contributions Credit. You have to be over 18, ave an AGI below certain thresholds, and make a contribution to a retirement savings plan. The credit may be 10-50% of whatever you put into your IRA. Consider this rather like free matching funds and make sure that if you're qualified, you get credit for it when you do your taxes. For more information about the Saver's credit, here's a link to an article at the IRS: http://www.irs.gov/newsroom/article/0,,id=107686,00.html
For more information about IRAs, see IRS Publication 590, available here:
as a web page: www.irs.gov/publications/p590/index.html
or as a PDF: www.irs.gov/pub/irs-pdf/p590.pdf