Even though tax season is winding down, it’s not too late to fund an IRA. But what is an IRA and why should you buy one? How do they work? These are important questions to ask because IRAs are some of the very best ways to secure your financial future. And if you ignore the IRA, you’re leaving a lot of easy money on the table Pilgrim.
No worries. By the time you finish reading this post you’ll know the answers to these questions and that will empower you to make smarter investment and financial decisions. Lets go for it.
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 how to deal with IRA beneficiaries before, so I won’t be covering that here either.
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 on any capital gains. You only pay tax on the money you withdraw when you withdraw it. The tax you pay depends on your income tax rate at that time.
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 reduce your taxable income by $5,000. That means 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 by making the IRA contribution. Sweet.
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. In other words, that $2000 in taxes belongs to the government once you earn that $5,000. There is nothing you can do about that. But if you make an IRA contribution, you get to use the government’s money for decades. That should put a smile on your face. 🙂
Q. Are there any other benefits to having an IRA?
A. Besides the tax advantage, the main benefit is that people tend to save this money rather than spend it. It’s a forced savings. Since you’ll get dinged 10% on top of the income tax if you touch the money prior to 59 1/2, it is money people rarely spend unless there is no other choice. 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 are 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. Maybe. This gives you more control over the money and more investment options as well. The plans at work usually offer limited investment choices. (Read my post on what to do with your 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 get to make your own investment decisions with full knowledge and with many more choices.
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 as I mentioned above. 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 or you can read my explanation of required minimum 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, you must replace the money within 60 days. If you don’t do that it will be considered a taxable distribution. Bad tone.
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 – or that it’s a good investment. For example, the IRS will allow you to buy real estate in your IRA…but your custodian may not be OK with it. 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. That will force you to budget in the dough so you’ll have the cash to fund your IRA.
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. For DIY investors, Tradeking is one option I really like. They have a fantastic platform and great resources to help you learn.
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?
I need to take money from my IRA because of hardship. My husband got laid off and the severance pay is almost gone and it’s Christmas. I am 59 and 4 months old. Is this close enough to 59 1/2 to avoid the penalty?
Neal Frankle, CFP ® says
I would check w/your tax professional. Thanks, Neal
Very thorough! This really is everything you need to know about an IRA including a few things I didn’t know. Great work.