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7 IRA Terms It’s Important To Know

Man fanning money next to earYou do have an IRA don’t you? If you don’t, you’re missing out on one of the best things you can do financially. In fact, most financial experts will tell you that if your employer doesn’t have a 401(k) plan, an IRA is your best steppingstone towards a decent retirement.

What is an IRA?

If you’re not familiar with an IRA, this stands for Individual Retirement Account. It’s an account established at a financial institution where you can save money for retirement with tax-free growth on a tax-deferred basis. In other words, the money you put into an IRA is tax-free. However when you take it out at age 55 1/2 or whatever, you will be taxed on it.

Three types

There are three types of IRAs. They are:

Traditional IRA


This is where you make contributions with money that you should be able to deduct on your taxes. Any money that your investments earn is potentially tax-deferred until you withdraw the money in retirement. If you’re typical you will find yourself in a lower tax bracket when you retire so that the money you take out will probably be taxed at a lower rate.

Roth IRA

This is where you make contributions to your account with money that you’ve already paid taxes on (after-tax) and it’s likely that your money will grow tax-free. When you withdraw the money in retirement you probably will not have to pay taxes on it – provided that you meet certain conditions . The following video with Suze Orman explains where to open a Roth IRA but her advice would likely be the same for opening a traditional IRA.

 

Rollover IRA

This is a traditional IRA funded with money rolled over from a qualified retirement plan. A rollover generally means moving your money from an employee-sponsored plan such as a 401(k) or 403(b) into an IRA.

Which should you choose?

Both Traditional and Roth IRAs have great tax benefits that allow your savings to potentially grow – or compound – more quickly than a taxable account. The best way for you to determine which of these would be best for you is to use a Roth vs. Traditional IRA Calculator, which is available on many websites including Fidelity.com.

Why invest in IRA?

Most financial experts say that you need up to 85% of your pre-retirement income in order to enjoy a decent retirement. You might be able to accumulate that much money in an employer-sponsored plan such as a 401(k). However, this might not be enough to accumulate all the money you will need. Fortunately, you can contribute to both an IRA and a 401(k). Naturally, your goal should be to contribute the maximum amount to your IRA each year. This year the maximum amount you can contribute to a traditional IRA is $5,500. However, if you are age 55-plus, the maximum contribution goes to $6,500. Roth IRAs are a bit more complicated and you should go to a website such Bankrate.com or Fidelity.com to learn exactly how much you could contribute to a Roth IRA.

The other advantages of an IRA
save money sign

One of the main benefits of an IRA is one that we mentioned in a previous paragraph. It allows you to supplement your current savings in an employer-sponsored retirement plan. But there are two other important benefits. First, in most cases an IRA permits you to access a wider range of investments then your employer-sponsored plan. And second, it allows you to take advantage of tax-deferred or tax-free growth.

Important IRA terms to know

If you do have an IRA or are thinking of starting one, there are some terms that are important for you to know and here are seven of them.

Adjusted gross income or AGI

Your AGI is used to determine your federal income tax. It includes all the taxable income that you received the past year such as wages, interest, capital gains and dividends minus things like moving expenses, business expenses, capital losses, alimony, and contributions to qualified IRA.

Retirement plan contribution

You can put money into an IRA as long as you earn money. And if you are age 55-plus, you can make some additional contributions. However, regardless of your age your contributions can’t exceed your earned income.

Non-deductible or deductible

If you are in a plan such as a 401(k), it’s possible that you could still deduct your contributions to an IRA. This will depend on your filing status and income. In comparison, the contributions you make to a Roth IRA are not tax deductible.

MAGI or Modified adjusted gross income

Some people use their MAGI to determine how much they can contribute to an IRA. However, for most people their MAGI will be the line on the tax form labeled “adjusted gross income,” or AGI. However, some taxpayers will choose to modify their AGI by adding back some of their tax breaks or income. These add backs can be anything from foreign income that you didn’t have to include in your adjusted gross income to income from series EE bonds and from qualified educational costs to contributions to a traditional IRA.

Required minimum distribution

In the event you have a traditional IRA, the law requires you to begin withdrawing money from the account by or before April first of the year after you become 70 1/2. The amount you will be required to withdraw will be based on your life expectancy and your age. There are simplified tables on the IRS website you could use to calculate what your required minimum distribution will be. Be aware that if you don’t make those withdrawals on time, you will be hit with an excise tax. If you have a Roth IRA it will not be subject to a required minimum distribution until you die.

Rollover

This is the word used when you reinvest money from one tax-deferred retirement plan to another within 60 days. As a general rule, 20% of the funds you roll over will be withhold for tax purposes if you take possession of the funds. The way to avoid this is by doing a direct rollover, which is a trustee-to-trustee transfer instead of from one retirement account to another.

Tax- and penalty-free withdrawals

The law says that you can withdraw money from your IRA without paying any taxes or penalties so long as you pay it all back within 60 days. However, be aware that you can only do this once a year. While these are not supposed to be used as 60-day loans, some account holders use this rule to loan money to themselves. Many financial experts warn against this. They say the situation comes with many dangers including not having the money, missing the 60-day deadline and incurring taxes. One financial advisor says that using the money from an IRA as a fast loan should be a last resort.

Education IRA

Some years ago this was renamed the Coverdell Education Savings account. However, you might still hear the term Education IRA. Since this account is not used to finance retirement it is not strictly an IRA. But when it was created its rules made people think of an IRA, hence the nickname. You can make contributions to a Coverdell Education Savings account of up to $2000 per child to help with educational costs. While you can’t deduct the contributions from your income taxes, the money you earn will be tax deferred and in the case of certain schools the money you withdraw will be tax-free.

Which is better – A 401(k) Or A Roth IRA?

If you’re worried about saving for retirement, you may be asking which would be better a 401(k) or Roth IRA. If you don’t have an emergency fund, the answer is “none of the above”. It’s really important to have the equivalent of five to six months of earnings saved up before you begin saving for retirement. The reason for this is simple. If you don’t have an emergency fund and you’re suddenly faced with a big auto repair or medical bill, you would have to either dip into your retirement account or use credit, neither of which is a good alternative.Egg labeled 401k in nest as next egg

Does your company offer a 401(k)?

If your company offers a 401(k) plan, this is a much better option than starting a Roth or traditional IRA. This is because with a 401(k) plan, your employer will probably match a percentage of your contribution. The contributions you make to the plan will be salary reduction contributions on a post-tax or pre-tax basis. The plan may even include a profit-sharing feature. Any money earned in the plan accrues on a tax-deferred basis. Your plan may even allow you to direct your own investments with a group of investment products from which to choose.

Your employer’s contribution

If your employer contributes to your 401(k) plan it will be at the rate of fifty cents for every dollar you contribute up to a certain percentage of your salary. This will be either 3% or 5%. As an example of what this means if you were to contribute $3,000 over the course of a year, your employer would kick in an additional $1,500.

If there is no 401(k) plan

Unfortunately, some companies do not offer 401(k) plans. If your company is one of them, the true question isn’t which is better a 401(k) plan or a Roth IRA. The real question is which is better a Roth IRA or a traditional IRA as these will be your choices.

The difference

The biggest difference between a traditional and a Roth IRA is that the contributions you make to a standard IRA are tax deductible, while those you would make to a Roth are not. In other words, you can deduct the money you put in a traditional IRA but will pay taxes on it when you withdraw the money. In comparison, with a Roth IRA you cannot deduct your contribution but you pay no taxes on the money when you withdraw it, assuming you’ve had your Roth IRA for five years or more.

Maximum contributions

With either a traditional or Roth IRA, the most you can put into the plan each year is governed by law. For example, this year the maximum amount you can donate to a traditional IRA is $5,500 ($6,500 if you’re 50 or older) and ditto a Roth IRA.

Choose a 401(k) if possible

If your company does offer a 401(k), it’s a much better option than either a traditional or Roth IRA. However, if it does not have a 401(k) plan you’ll have to check out the details of both a traditional and Roth IRA and then make a decision based on which one makes the most sense for you. given your tax situation and retirement goals.

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