Keeping your finances straight on a weekly or monthly basis can be complicated enough. Trying to plan for your future at the same time can seem completely overwhelming. But especially for those who are self-employed and therefore not expecting to pull a pension later in life, thinking about your financial future is absolutely essential.
By planning smart and planning ahead, you can prepare yourself to retire with confidence. The first step in planning is to open an Individual Retirement Account (IRA).
Although the jargon of wealth management can get confusing, an Individual Retirement Account, or IRA, is simply a type of savings account specifically for retirement. Because of this special designation, the money put into this account qualifies for tax advantages and exceptions in the United States.
Although IRAs were created in 1974 with the Employee Retirement Income Security Act, regulations regarding the accounts have changed over the years. Originally, taxpayers not covered under an employment-based retirement plan could move up to $1,500 per year into the account and reduce their taxable income by that amount.
The amount has since been raised to $5,000 a year, and all taxpayers are eligible (although the tax-deductible status varies depending on income level, with those in the highest income brackets eligible for fewer deductions). People over 50 years of age can also make a “Catch-up Contribution” to make up for the changes in allowable amounts.
Part of the confusion around IRAs is related to the different types available. The different types and subtypes of IRAs may benefit contributors differently. These include:
- Traditional IRA: All contributions, transactions, and earnings within the IRA are tax-deductible. Any withdrawals at the time of retirement are considered as income.
- Roth IRA: This more recent type was named for Senator William V. Roth, Jr., and was introduced as part of the Taxpayer Relief Act of 1997. All contributions are made after-tax assets, and the withdrawals are usually not taxed.
- SIMPLE IRA: This type of IRA involves contributions by both employers and employees. It is similar to a 401(K) plan, but has lower limits and more simple administration. Although it bears the title of IRA, it is often treated quite differently.
- SEP IRA: This allows only the employer to make retirement contributions into an IRA established in the name of an employee, rather than a pension fund. It is a great option for small business owners or self-employed taxpayers who want to simplify business operations while preparing for retirement.
- Self-Directed IRA: This is a step beyond just a savings account. This type of IRA allows the account holder to make investments on behalf of the plan.
- Rollover IRAs and Conduit IRAs: These are two more types of IRAs that are no longer used because of changes in tax law, although some people may still maintain these older accounts to keep track of their finances.
Because IRAs receive such an important tax exemption status, there are a number of regulations that one must follow in order to maintain that status and fulfill the law. The first important regulation is in regards to what type of assets may be held in the IRA.
- An IRA can only be funded with cash or a cash equivalent, which means assets such as collectibles and life insurance are disallowed.
- Items like real estate become more complicated; they can be held in an IRA, but not if the owner receives some kind of current benefit from the property, like if they act as a landlord. However, rollovers, transfers, and conversions between IRAs can include any asset.
- There is a deductibility phaseout limit for individuals and married couples filing jointly.
- Once the money is inside the IRA, the owner of the account can direct the custodian to use the cash to purchase securities and invest the funds. The owner cannot, however, pledge the IRA as security against a debt.
Protections on the Funds
One of the benefits of having an IRA is its protected status against creditors. Following a 2005 Supreme Court decision, Rousey v. Jacoway, a debtor in bankruptcy can exempt his or her IRA from the bankruptcy estate. This includes up to $1 million in assets for both Traditional and Roth IRAs. That makes an IRA a smart choice for the long-term; finances can be unpredictable, but an IRA can assure you that you can put your bankruptcy behind you and still retire successfully.
There are, however, restrictions placed on the owner of the IRA if there is a withdrawal of funds. Although you may withdraw funds at any time, this will affect the tax-exempt status.
- Typically, you can withdraw money penalty-free as taxable income after reaching the age of 59 and six months.
- Non-Roth IRA accounts must use half of the contributions before reaching age 70 and six months.
- Finally, distributions from the account continue after the death of the account-owner to a designated beneficiary.
Of course, there are loopholes and exceptions to those policies. Disability, medical expenses, education expenses for children or grandchildren, and the purchase or rebuilding of a home are all factors that may allow for non-taxed withdrawals.
An owner cannot borrow money from the account, although indirect rollovers can be performed that allow for a type of borrowing. The law can also get complicated in regards to foreign dividends, so account holders can be more assured that their funds are deductible if they originate in the United States.
There are several resources offered through wealth management agencies and websites that can help you open and manage an IRA. For example, bankrate.com has an online Traditional IRA calculator to give you a good prediction of how much you can save. Also check out IRA.com (The Internet Retirement Alliance) for recent articles and news about tax law changes and retirement advice.
Although decisions regarding the distribution of funds should be made carefully, this should not discourage you from beginning to save and plan ahead. The sooner you start, the sooner you can retire in confidence and enjoy the rewards of your hard work!