Have you ever started reading an article only to realize halfway through that there is an important acronym being used repeatedly and you have no idea what it stands for or what it means? That is exactly how a conversation about retirement can feel if you are unfamiliar with the acronym IRA.
Although many people believe IRA stands for individual retirement account, the IRS defines it as individual retirement arrangement. Either way, the name correctly suggests that an IRA is a way for individuals to save for retirement. In this blog post, I will discuss some of the key aspects of an IRA and why it may be beneficial to those trying to save for retirement.
An IRA is established with a custodian, which is an approved financial institution, such as a bank, credit union, brokerage, insurance company, or mutual fund company. Once established, an IRA acts as a bucket that can hold cash and investments that are intended for retirement. This brings up the important distinction that an IRA is not an investment itself; instead, an IRA holds investments. Furthermore, because monies contributed to an IRA are intended for retirement, savers should plan on leaving them within the IRA until at least age 59½ for reasons addressed below.
In general, because individuals using an IRA are saving for long-term needs, IRA contributions are often invested with the goal of achieving a return over time. Some of the most common types of investments used in an IRA include mutual funds, individual stocks, and bonds. One of the benefits of using investments to save for retirement is the time value of money, which may allow your retirement savings to grow over time.
The primary benefits of saving in an IRA are tax-related. Assuming you meet certain criteria in regards to your age, income, tax-filing status, and access to an employer-sponsored retirement plan, taxation of your contributions and investment earnings is deferred until funds are withdrawn from the IRA. In other words, qualified IRA contributions reduce one’s taxable income dollar for dollar and investment earnings are taxed when they are withdrawn from the IRA rather than in the year they are realized. However, it is important to note that, except under certain circumstances, withdrawing funds from an IRA before age 59½ can result in a 10% penalty in addition to regular income taxes on any part of the withdrawal that must be included in your gross income.
However, if taxes must ultimately be paid when funds are withdrawn, you may be questioning the benefits of an IRA. In general, a person attains their highest tax bracket in their working years. In retirement, income generally decreases, which may lower your income tax bracket. Therefore, the benefit of an IRA is that it shelters income from the higher tax brackets of the working years and defers it to the presumably lower tax brackets of retirement. Accordingly, the tax saving benefits of an IRA are generally greatest for those whose income puts them in a high tax bracket.
In summary, an IRA is a tax-advantaged account that holds cash and investments intended to help individuals save for retirement. By deferring taxation of IRA contributions and earnings, individuals may be able to shelter those monies from the high tax brackets of their working years. For more information about IRAs and to determine whether one would be beneficial to you, contact your financial advisor or send me a question in the “Have a Question?” box below.