“IRA” is a well-known financial term, even if not always well understood. It stands for Individual Retirement Account.
There are basically two types of IRAs: A “traditional” IRA (allowing pre-tax contributions) and a “Roth” IRA. (I am ignoring other variations such as roll-overs and retirement plan IRAs).
The “traditional” IRA allows tax-deductible contributions, under the proper circumstances, and grows tax-deferred. However, earnings and withdrawals will be subject to tax in the future, and there will be required minimum distributions in the future.
That said, I would like to focus, instead, on the Roth IRA because of a number of benefits. These include:
– Withdrawal of earnings is tax-free and penalty-free if holding period and age requirements are met
– Contributions are always available for penalty-free withdrawal
– There are no Required Minimum Distributions (RMDs) to worry about
– Contributions can be made as long as the account owner has income
– There is no minimum age or age cutoff for making contributions if other conditions are met
So major benefits as I see them are: the protection against tax effects on account earnings and the penalty-free access to personal contributions at all times. Also, the fact there is no requirement to withdraw funds at a particular age means funds can essentially grow over an unlimited period of time if the account owner does not need to draw on the funds. All the funds can potentially become part of the estate left to children or other beneficiaries.
The basic conditions that must be met to take full advantage of a Roth are:
– The account owner must have earned income (basically salary or commission, not pension)
– Earned income must be at least equal to the amount being contributed to the Roth
– Hold the account for 5 years and beyond age 59 ½ to avoid penalties (there are exceptions)
– For maximum 2011 contribution 2011 income less than $169,000 (joint), $107,000 (single)
– Contribute after-tax income
Up to $5,000 can be contributed or up to $6,000 if the account owner is over age 50. A non-working spouse may also be able to open a Roth account. While it is possible to contribute to both a traditional and a Roth IRA at the same time, contributions to each IRA are combined to determine when the annual contribution maximum of $5,000 (or $6,000 if over age 50) is reached.
Consider setting up an automatic savings program to add funds to your Roth account on a regular basis.
When to consider contributing to a Roth:
– After you have maximized any employer matching for 401(k), or other retirement plan, contributions
– If you believe you need to hedge against future tax rate increases rather than put pre-tax money in a traditional IRA now
I encourage you to give proper consideration to the Roth IRA, and its benefits, as a savings and investment vehicle.