You might have heard a lot about individual retirement accounts (IRAs) but know very little about what they are or how they can help you reach your retirement goal. Instead of bogging you down with a whole of lot of technicalities, let's take a look at the basics of the IRA. What do you need to know before you get started? (For related reading, see 11 Things You May Not Know About Your IRA.)
An individual retirement account or IRA is a vehicle set up to help you reach your retirement goals. We've all heard that having all of our financial eggs in one basket is a bad idea. So the Internal Revenue Service (IRS) set up the IRA with similar tax benefits as a 401(k) that you may have at work. It's a good idea to have both a 401(k) and an IRA to remain diversified.
The IRS allows you to deposit up to $5,000 per year if you're under the age of 50 and $6,000 per year if you're over 50. These maximums will stay in place for the 2012 tax year but may change in future years. You must also have earned income to contribute to an IRA, but that could include a spouse if you're married.
What can quickly turn people off to the IRA is the fact that there are two different types of IRAs. The traditional IRA doesn't require that you pay taxes on your gains until you start taking distributions. (Distribution is the term used to describe the withdrawals you make once you reach retirement age.) The traditional IRA keeps more money in your account over time and that allows the money to compound at a faster rate.
The Roth IRA requires that you pay taxes now, at your current rate, because the money you're contributing was already taxed before you received your check. This allows your earnings to grow tax fee, and if you anticipate being in a higher tax bracket in the future, the Roth is probably your best choice. (For additional reading, see Roth Vs. Traditional IRA: Which Is Right For You?)
With both IRAs there are eligibility requirements. With the traditional IRA, you can only deduct your contributions if your family earnings fall below certain maximums and if you're covered under an employee sponsored plan like a 401(k). According to the Vanguard Group, if your traditional IRA isn't deductible, a Roth IRA is the better choice. With the Roth, your contributions are never deductible and there are income limits. If you're single and make more than $125,000 in 2012, you aren't eligible to open a Roth.
Fact 4: The Costs
In order to open an IRA, you'll need a bank or investment broker. Some of the discount brokers offer no-fee IRAs other than the commissions charged to buy and sell within the account. Other brokers will charge a yearly management fee even if they aren't managing the account for you. Look for a no fee IRA. If you're charged a 1% management fee, that could equate to a 30% lower balance over a 30 year period. So keeping fees to a minimum is key.
Whether it's a Roth or traditional IRA, get started. The money that is sitting in your savings account earning little to no interest could work harder for you in an IRA with safe investment choices. Don't know how to invest the money? Ask a fee only advisor for some help. Many are happy to charge you a one-time fee and a fee for an annual consultation. (To learn more, check out Paying Your Investment Advisor - Fees Or Commissions?)