IRA FAQs – All the Answers You Need in Plain English

by Neal Frankle, CFP ®

This is my IRA FAQ post. I’ve tried to put everything together for you in one place – or lead you to other posts here at Wealth Pilgrim that answer all your questions. Let me know if there is something I’ve left out. Thanks…

There is no better way to make smart investments for retirement income than by understanding and taking advantage of IRA accounts and investments. (For purposes of this post, I’m only going to talk about the IRA. I’m not going to address the Roth IRA or any other retirement account such as the SEP, SIMPLE IRA or Individual 401k. I have written about those types of accounts on prior occasions. Also, I’ve written about the best way to protect IRA beneficiaries before, so I won’t be covering that here either.

Let’s dig in:

Q. What is an IRA?

A. An IRA is an account that allows you to set money aside for your future. When you deposit money into the account, you get a tax deduction. While the money is in the account, you pay no taxes on the interest it earns or any capital gains. You only pay tax on the money you withdraw when you withdraw it.

Q. Why should I care about getting a tax deduction now?

A. Let’s say you make $40,000 a year and you are in the 40% tax bracket. If you make a $5,000 contribution to your IRA, you only pay tax on $35,000 of income. That extra $5,000 would have been taxed at 40% – or $2,000. So, you saved yourself $2,000 in taxes. That, my friend is PDG – Pretty Darn Good. It’s a great way to help you have enough money to retire.

Q. But if I have to pay the tax anyway at some point, what difference does it make?

A. Let’s look at the example above. By making the $5,000 IRA contribution, you saved yourself $2,000 in taxes. It’s true that down the line, you’ll have to fork over that $2,000 to the IRS (assuming tax rates stay the same and you remain in the same bracket). But you get to use that $2,000 for a very long time. And you can invest that $2,000 and keep most of the interest forever. That’s the benefit.

Think of it this way. If you give me $1,000,000 today and I offer to repay you $1,000,000 in 20 years, would you take that deal? Of course not. You want to invest your $1,000,000 and earn interest on it rather than let me keep the interest. The IRA allows you to take the government’s money (that $2,000 tax on the $5,000) and invest it so long as you repay that $2,000 down the line. It’s sweet-a-kimbo.

Q. Are there any other benefits to having an IRA?

A. The main benefit is that people tend to save this money. It helps them spend less money. It’s a forced savings, if you will. That’s why most people have most of their liquid net worth in retirement accounts.

Q. When should I open an IRA?

A. How about yesterday? The sooner you open and fund your IRA the sooner you’ll start using the government’s money to earn interest for yourself. Capiche?

Q. What does “IRA” stand for?

A. While it’s commonly referred to as Individual Retirement Account, the IRS defines it as an Individual Retirement Arrangement. There…now you can show off to all your snooty friends.

Q. Can I contribute to an IRA even if I have other retirement plans?

A. Yep. You sure can. However, you may not be able to deduct your contributions if you or your spouse is covered by a retirement plan offered at work. It depends on your income. Read “IRA Restrictions.”

Q. When I leave my job, should I roll my retirement plan into an IRA?

A. Probably. This gives you more control over the money and more options as well. The plans at work usually offer limited investment choices. (Read my post on what to do with your old 401k). Also, it’s sometimes difficult to track the investments in a 401k or 403b. In contrast, you have thousands of choices when it comes to an IRA. This also helps you control costs. The plans at work don’t usually disclose fund expenses, but those funds do have costs and you pay them. By rolling your employer plan to an IRA when you separate from service, you can select investments and know the fees they charge.

Q. If I put money into an IRA, when can I get the money out?

A. Anytime you want. However, when you withdraw money from an IRA, you will pay income tax on every dime you withdraw. And if you take money out before you reach 59 1/2, you’ll pay a 10% penalty to boot. So you CAN take money any time you want, but it’s usually better if you keep the money in the account as long as possible.

Q. When do I have to start taking money out of my IRA?

A. At age 70 1/2. The law actually states that you have to start taking withdrawals the year after the year in which you turn 70 1/2. But if you do wait, you’ll have to take two distributions that year; one by April 1 and the second by December 31. Most people like to keep it simple and just start taking the distributions the year they turn 70 1/2.

Q. What if I don’t need the money or I’m still working when I’m 70 1/2?

A. The IRS doesn’t care. You still have to take your distributions and pay the tax.

Q. How much must I withdraw at 70 1/2?

A. It’s based on the value of the account as of December 31 the year before you reach 70 1/2. The first year, it’s about 1/20th of the account. The percentage goes up slightly each year. You can get Publication 590 to get further details on distributions.

Q. Do I have to worry about calculating how much I have to withdraw?

A. Not really. The custodian who holds your account usually does this calculation for you. If you have an inherited IRA, you should do the calculation yourself or ask your CPA to do it. The custodians don’t quite do it right.

Q. Can I borrow against my IRA?

A. Thankfully not. If you absolutely must take money out of your account, it will be considered a taxable distribution.

Q. Can I invest my IRA as I see fit?

Other than collectibles (art, rugs, antiques, stamps, coins, etc.) you can invest as you like.

But keep in mind that just because the IRS allows it, doesn’t mean your custodian will. For example, the IRS is fine with your buying real estate in your IRA…but your custodian may not be. Make sure to check with your IRA custodian before opening an account.

Q. If my IRA loses money, can I claim a tax deduction?

A. Nope. You don’t pay taxes on anything you make on your IRA and you don’t claim tax benefits for any losses you incur. In most cases, you get a deduction when you deposit the money and you pay tax on the money when you make a withdrawal. End of story.

Q. What if I don’t have the money to fund my IRA?

A. Find it. Cut spending. Track your spending and make cuts. It’s not as difficult as you think. I strongly recommend using a system to track your spending like You Need A Budget. It’s a wonderful tool.

Q: How do I open an IRA?

A. This is super easy. Most banks, brokerages and financial institutions would love to help you. They have the forms and they’ll complete them for you in many cases. Just make sure you know how much you’re going to start with and what kind of investments you want to make. Some custodians have minimums and other restrictions. Check before you open your account.

Q: All right then, what type of investments should I make in my IRA?

A: I’ve written an entire post on how to invest for retirement.

Is there anything else you’d like to know about IRAs? What other questions do you have?

While you’re considering that, let’s move on to the coveted “Pilgrim Parade of Posts”:

Here are the carnivals I participated in and the posts I think you’ll enjoy checking out this week:

Yakezie Challenge Blog Carnival

Carnival of Money Stories

Carnival of Personal Finance

Festival of Frugality

8 Exceptions to the 10% Penalty for IRA Withdrawals – Jason@ Redeeming Riches

How to Successfully Budget for an Irregular Income – Joe Plemon

Backyard Investment – Carol Schultz

Residential Real Estate Investing – Part 2 = Carol Schultz

Vanguard Target Retirement 2055: Why the Minimum Investment? – My bud Mike Piper

3 Things to do with your online cashback earnings – Digerati Life

How to Save Money for Your Dream – Moolanomy

How to find the best financial planner – Debt Free Adventure

101 Ways to Save Money – THE MONEVATOR!

Retirement or College Tuition? – Joe Taxpayer

Basics of 529 Plans – Kelly, My Centsible Life

How to get a raise…after a raise – The Financial Blogger

 

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{ 1 comment… read it below or add one }

Jesse September 3, 2010 at 12:47 PM

Very thorough! This really is everything you need to know about an IRA including a few things I didn’t know. Great work.

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