Retirement Accounts

The IRS understands that you need to save for retirement. Often your nest egg builds faster if you don’t have to pay taxes on retirement savings until you are ready to retire and withdraw your money. The idea is that you will be in a lower tax bracket once you retire. The money is taxed as it is withdrawn.

Retirement accounts through your employer, such as 401(k)s and company sponsored IRAs, give you added benefits. Your contributions to your account are made in pretax dollars, which means that you are saving more than if you only contributed after-tax dollars. Because you deduct your contributions from your gross income, you are paying less in taxes.

There are other accounts, such as Roth IRAs, that allow you to contribute after-tax dollars. Your earnings grow tax free because you’ve already paid the taxes on your contribution. When you withdraw the money, you don’t have to pay any taxes.

There are several tax-advantaged retirement plans to help you save for your future.

Individual Retirement Accounts

Individual Retirement Accounts (IRAs) give you a great way to build tax-deferred savings for your retirement. An IRA is not an investment, it is an account. Within the account is a mixture of the investments that you want – stocks, CDs, mutual funds, cash and bonds. You can have any mixture of investments you want, and everything except options and other derivatives.

Employees can no longer plan for their future based on the promise of Social Security and pension plans. As corporate America has switched to “defined contribution” retirement plans, the American worker is on his own for saving for retirement.

“Defined contribution” plans specify the maximum amount an employee can contribute to a plan, but they do not guarantee any amount of payout. A “defined benefit” means that the company’s plan guarantees a specific payout. In general, the burden of funding your retirement is no longer with an employer, but with you.

The Traditional IRA

The traditional IRA is the most popular form of an IRA. Anyone under the age of 70 ½, with earned income, can open and invest in a traditional IRA. There are limits to how much you can contribute to your IRA each year.

If you don’t have a retirement plan at work, you will be rewarded for making contributions to an IRA. You can deduct your IRA contributions from your gross income for tax purposes. It lowers your Adjusted Gross Income, which means you are taxed at a lower amount of income. You earnings in an IRA will grow tax-deferred until you withdraw them at retirement.

Even if you are covered by a retirement plan at work, you can contribute to an IRA. The contributions are not tax deductible, but the earnings still grow tax-deferred.

You can begin withdrawing money, called taking distributions, beginning at age 59 ½ if the account has been open for at least five years. If you opened the account at age 55, you will have to wait until you are 60 to take distributions. You are required to begin taking minimum distributions by April 1 of the year after you turn 70 ½.

The disadvantage of IRAs falls here. The distributions are taxed as ordinary income.

Since IRAs are set up for your retirement and withdrawals before the age 59 ½ are taxed as ordinary income and charged with an IRS penalty of 10%. There are some exceptions. You may be able to withdraw money penalty-free before the age of 59 ½ to buy your first home, pay for higher education or extraordinary medical costs, or because of disability or death.

You can take a penalty-free loan from your IRA, but you have to start to repay the money within 60 days or pay taxes and a 10 % IRS penalty.

Roth IRA

Contributions to a Roth IRA are not tax deductible, you use after-tax money. The earnings will still grow tax free. Unlike a traditional IRA, you may withdraw your contributions at any time without penalty. You aren’t required to take distributions until you want to.

The limits of how much you can contribute to your Roth IRA are similar to traditional IRAs. As long as you have earned income that is equal to the amount of your contribution and you meet the income restrictions, you can open a Roth IRA. You are allowed to have a Roth IRA even if you already have a traditional IRA and a 401(k).

The biggest advantage to the Roth IRA is that your withdrawals are tax free. If you are a smart investor and manage your account successfully, this could really pay off for you. You can open either a traditional IRA or a Roth IRA through any brokerage firm, bank, credit union or mutual fund company.

You can either start a Roth IRA by opening a new account and funding it with new money or convert assets from a traditional IRA to a Roth. If you convert a traditional IRA to a Roth you will have to pay the taxes on the money before it goes into the Roth. You have to know how you will pay the tax on the earnings from the IRA. The money is taxed as ordinary income. You don’t necessarily want to use money from within the IRA to pay the taxes; you will sacrifice your investment potential by doing so. You can convert your IRA to a Roth IRA a piece at a time, giving you the ability to pay the taxes gradually.

Self-directed IRA

If you set an IRA with a brokerage it is considered a “self-directed” IRA. You decide how the money will be invested, in stocks, bonds, mutual funds, certificates of deposit or even in real estate.

Any brokerage can help you open a self-directed IRA. Brokerage websites have plenty of information on the necessary steps. You can either fund your IRA with new money or roll over a company-sponsored retirement plan into it. Make sure if you roll over your retirement plan that they send the check directly to the brokerage. If you receive the money in your name, you could be taxed and penalized by the IRS. The brokerage will give you all of the necessary details.

SEP-IRA (Simplified Employee Pension)

A SEP-IRA is a company sponsored IRA that can be opened by the smallest of businesses and the sole proprietor. With this plan, an employer can contribute to his or her own retirement plus to an employee’s existing IRA. The employee IRAs are owned and controlled by the employee. The employer is simply making contributions to the financial institution that maintains the IRA.

SEP-IRAs are subject to the same taxes and withdrawals penalties as are traditional IRAs. The employer receives a tax deduction for all contributions made. These IRAs are flexible. The employer doesn’t have to contribute on a regular schedule, every year.

SIMPLE IRA (Savings Incentive Match Plan for Employees)

Small businesses up to 100 or fewer employees who make at least $5,000 each can set up this company sponsored plan. This can be set up at a company designated financial institution or at any institution chosen by the employee. The SIMPLE is a savings incentive match plan. The employer matches or non-elective contributions to the employees plan.

Martin Lukac
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