A frequently-mentioned (but often poorly-explained) aspect of investing for retirement is the Individual Retirement Account, or IRA. They are popular for good reason: the tax advantages they can afford you are enormous, as are the eventual disbursements when you reach retirement age.
We thought it would be a good idea to lay out some of the basic facts about IRAs, including what they are, how to get started investing in your own IRA, and mistakes to avoid along the way.
The Basics
First, you need to know what an IRA does. In the simplest terms, a traditional IRA allows you to deduct a portion of your taxable income and invest it for retirement. A different version, called a Roth IRA, does not allow you to deduct your contributions, but allows you to withdraw your eventual earnings tax free. There are other versions of IRAs, but for our purposes, the two most popular will do just fine.
Which of these versions is better? That usually depends on the amount of money you make, how much you plan to contribute, and whether you’d rather pay taxes now or later. Contributions, as of 2023, are capped at $6,500 annually. If deducting that from your income would confer a significant tax advantage to you, and you plan on sticking to your retirement plan, then generally it’s recommended to go with the traditional IRA. If you think that tax rates will rise by the time you reach retirement age, then the Roth IRA is the option for you.
Why an IRA?
A couple of reasons. One is the aforementioned immediate tax benefit from a traditional IRA. Another is that it can run parallel to other retirement vehicles, such as an employer-sponsored 401k, and earn interest right alongside them. Returns on IRAs are also attractive, averaging around 8-9% annually. There are no minimum contribution or initial deposit requirements, and IRAs can even be bequeathed to a beneficiary in the event of an accident or untimely death.
Another attractive benefit of IRAs is their stability. IRAs are managed by “custodians,” which are the entities you trust to hold your assets. Banks, insurance companies, and mutual funds are all examples of potential custodians, and their inherently solid nature serves as a bulwark against market fluctuation.
Getting Started
You’ve decided you’d like to begin contributing to an IRA. Where to start? First thing’s first: you need a trusted partner to help you navigate the process (hint-hint). Once you’ve learned about which IRA is right for you, decided who your custodian will be, and landed on a contribution target, you’re ready to start investing. It really is that simple!
Avoid These Mistakes:
So what’s the catch? Besides being a bit confusing, IRAs are really not that intimidating. However, there are a few missteps that can cause you headaches in the future.
Withdrawing Early
As with most retirement accounts, IRAs must reach “maturity” before you begin making withdrawals from the account. You will be penalized an additional 10% tax for withdrawals from a traditional IRA if you make them before the age of 59 ½ years old. Once your money is in a traditional IRA, it’s there to stay.
Not Planning for Taxation
Distributions from a traditional IRA are treated as taxable income, and will be subject to the normal tax rate of your state when withdrawn in retirement. Generally, you’ll go over this with a financial advisor when opening an account, but it’s always good to remember that an IRA represents a tax benefit, not the avoidance of taxes entirely.
Not Naming a Beneficiary
Planning for the unexpected is incredibly important when you are dealing with large sums of money, especially ones earmarked for your non-working years. While in some cases the law may work to give your spouse or surviving estate possession of your IRA, it’s not wise to leave it to chance. Name your beneficiary clearly, and update according to your marital status and family situation later in life.
Retirement is one of the most important financial considerations of your lifetime. It can be a wonderful celebration of the end of your working days, or an enormous source of stress, and it all depends on how well you planned for it. Visit your local Equity Bank branch or contact us today to see what saving for retirement should look like for you.