Your IRA Retirement Plan
Advice for Tax-Free Savings Plans
Almost anyone can set up an IRA and start saving for retirement. Retirement can be the best time of your life if you have enough money to enjoy it. Plan ahead. Avoid coming up short when you retire.
- What is an Individual Retirement Account, IRA?
- How Much Money Will You Need to Retire?
- Three Steps to Set Up Your IRA Retirement Plan
- There are Three Types of Individual Retirement Accounts, IRAs
- How Much Can You Contribute to an IRA Retirement Plan?
- How Much of My IRA Contribution Can I Deduct?
- Making Withdrawals from Your Regular IRA Retirement Plan
- How to Avoid the Penalty for Early Withdrawal From an IRA Retirement Plan
- The Regular IRA Retirement Plan Has an Penalty for Under-Withdrawing
- Use an IRA Retirement Account for Estate Planning
1. What is an Individual Retirement Account, IRA?
An Individual Retirement Arrangement (or IRA) is a retirement savings plan with tax advantages. Any person can set up an IRA and start saving for retirement. Retirement can be the best time of your life if you have enough money to enjoy it. Avoid coming up short when you retire.
You can set up an IRA Retirement Account for yourself as soon as you start earning income. The sooner you begin your IRA account, the sooner your money can start growing tax-free. And the earlier you start saving, the more money you'll have for retirement. The interest, dividends and capital gains that your money earns in your IRA account is tax-free. Albert Einstein said that compound interest was the most powerful force in the universe. He knew that investment earnings accumulate faster the longer you hold them.
2. How Much Money Will You Need to Retire?
How much money will you need to retire? On average, you'll need 70% to 80% of your current living expenses. If your home is paid for you can probably get by on less money.
Some of your retirement money will be provided by Social Security. How much will Social Security provide? If you have paid into Social Security the maximum taxable amount every year since you were 21, and if you retire at age 66 in 2009, you will receive $2,323 monthly, the maximum Social Security pays. However, it is unlikely that a person earns the maximum every year for 45 years. In January 2009, the average monthly Social Security check received by a retired worker was $1,090.
I retired early for health reasons — my company was sick of me and
I was sick of them. — Unknown retiree
3. Three Steps to Set Up Your IRA Retirement Plan
The first step to start a retirement IRA is to decide how your retirement money should be invested. Your IRA money can be held in a Certificate of Deposit (CDs), in a money market fund, or in a wide variety of investments. You can always change the investments in your IRA account at any time. A conservative investor will choose CDs which are guaranteed by the Federal Deposit Insurance Company, FDIC. Another conservative investor might choose an index mutual fund, like the Standard & Poors 500 Index Fund. The value of an index mutual fund is pegged to the value of a major stock market index, like the Dow Jones Industrials or the S&P 500.
- Next, decide if the Traditional IRA or the Roth IRA is best for you. For most of us, the Roth IRA has many advantages. See the next topic for more information.
- Open the account. If you want to use your IRA money to buy Certificates of Deposit that pay interest, talk to your banker. If you want to hold a variety of stocks in your IRA, talk to your stockbroker. If you want to hold mutual funds or stock index funds in your IRA account, talk to an investment firm with a large family of noload funds. Vanguard is one such firm. The bank or broker is called the custodian of your IRA account. You'll send them your IRA contribution money, and they'll take care of the paperwork. Call the toll-free number of the bank or brokerage and ask to open an IRA account. They will mail the application form for you to complete.
4. There are Three Types of Individual Retirement Accounts, IRAs
There are three types of IRA accounts that an individual can set up. In addition, there are several types of IRA accounts that an employer can set up, but we won't consider them here.
- Roth IRA. The Roth IRA is a newer, simpler retirement plan. For most people the Roth IRA is the best option. You contribute to your Roth IRA account with after-tax dollars, but you get no income tax deduction for the contribution. When you retire and make withdrawals, all the money you withdraw is tax-free. The money your Roth IRA earns over the years is tax-free, even when you withdraw it, as long as you are over 59 1/2 and have held the account for 5 years. Unlike the Regular IRA, you don't have to take minimum distributions from the Roth IRA Retirement Account when you are over 70 1/2.
- Traditional IRA, also called Regular IRA. You make contributions into the account every year up to the limit allowed. You take the IRA income tax deduction for your contributions. You are contributing before-tax dollars to your IRA. Over the years, your IRA account earnings are also tax-free. When you withdraw money at retirement, you pay income tax on all withdrawals, including what your account earned, as well as the amount you contributed. Regular IRAs have more rules and regulations than Roth IRAs.
- Traditional nondeductible IRA. This plan is most suitable for a high-income taxpayer who is covered by an employer's retirement plan. You contribute to your IRA, but do not take the IRA income tax deduction on your contributions. You are contributing after-tax dollars to your IRA. When you take retirement distributions from your IRA, the amount you contributed can be withdrawn tax-free. But the amount your IRA earned over the years is taxable whenever you withdraw some of it. Special computations are required on your income tax returns when you retire.
Retirement: Now I’m as free as the breeze — with roughly the same income. — Unknown retiree
5. How Much Can You Contribute to an IRA Retirement Plan?
The maximum contribution for 2008 is $5,000. The total you contribute to all your IRA accounts must be less than $5,000. If you are 50 or older, your maximum contribution for 2008 is $6,000. To make contributions to your IRA in any year, you must have earned income. Your contribution for the year cannot be more than your earned income.
Your spouse can also have an IRA with the same contribution limits, if your spouse has earned income of $5,000 or more. If only one spouse has earned income, both spouses may have individual IRAs with separate contribution limits of $5,000. Of course, your combined IRA contributions cannot exceed your combined earned income. Most married couples can contribute $10,000 toward their retirement this year, and $12,000 if you are both over 50.
Did you know? You can make your 2008 contribution to your Regular IRA as late as April 15, 2009, and still take the deduction on your 2008 income tax return.
6. How Much of My IRA Contribution Can I Deduct?
If you have a Roth IRA, you are not eligible for the income tax deduction.
If you have a traditional IRA, and you and your spouse are not covered by an employer's retirement plan, you can deduct the full amount of your contribution each year, up to the maximum limit. But, if you have a traditional IRA, and you are covered by your employer's retirement plan, the amount of your own IRA deduction on your income tax return may be reduced.
Let's suppose you are covered by an employer's retirement plan, If you are single, you can take the full IRA deduction if your modified AGI (Adjusted Gross Income) is less than $53,000. If you are married, and filing jointly, and you and your spouse are not covered by an employer's plan, you can take the full IRA deduction. If both spouses are covered by an employer's retirement plan, each spouse may deduct the full IRA contribution if the combined modified AGI is less than $85,000. For higher income taxpayers who are covered by an employer's retirement plan, the IRA deduction is reduced or eliminated.
Military personnel may also contribute to their IRA even though combat pay is non-taxable. In 2008, there are special catch-up contributions allowed for people who had non-taxable military combat pay in 2004 and 2005. You can claim the tax deduction by making a catch-up contribution and then filing an Amended Income Tax Return for those years.
In addition to the IRA deduction, there is a special IRA tax credit for low-income taxpayers. The tax credit is up to 50% of your IRA contribution, up to a maximum credit of $1,000. The tax credit is phased out for single taxpayers with AGI over $16,000, and phased out for married couples filing jointly with AGI over $32,000.
7. Making Withdrawals from Your Regular IRA Retirement Plan
The rules for withdrawing money from a Regular IRA are different from the rules for a Roth IRA.
When you take retirement distributions from your Regular IRA you must pay income tax on the money. You'll receive a Form 1099-R used for Distributions from pensions, annuities, retirement or profit-sharing plans, IRAs and Insurance Contracts. The Form 1099-R will be prepared by the custodian of your IRA, which could be your broker or bank.
Sometimes the amount you withdraw is not taxable. If you made nondeductible contributions to your Regular IRA, some of your distribution is not taxable, Report these nontaxable distributions on Form 8606. When you transfer an IRA account to a spouse as part of a divorce settlement or maintenance decree, the transfer is tax-free as long as no money is actually withdrawn.
8. How to Avoid the Penalty for Early Withdrawal From an IRA Retirement Plan
If you withdraw money from your Regular IRA before you turn 59 1/2, the money is taxable income, and it is also subject to a 10% penalty. If you withdraw money from your Roth IRA before you turn 59 1/2, the money is not taxable, but it is subject to a 10% penalty. You can claim an exception to the penalty for these reasons:
- the distribution was paid because of death or disability
- the distribution was rolled over to another IRA
- the distribution was used to pay medical expenses that amounted to more than 7.5% of your income
- the distribution was used to pay health insurance premiums after you were unemployed for 12 consecutive weeks
- a distribution of less than $10,000 is penalty-free if you used the distribution to purchase a home, provided that you haven't owned a home for 2 years
- you used the distribution to pay college expenses or graduate school expenses for yourself, your spouse, child or grandchild.
9. Regular IRA Retirement Plan Has an Penalty for Under-Withdrawing
The Roth IRA Retirement Plan does not require you to make withdrawals when you reach 70 1/2 or at any other age.
But if you have a Regular IRA Retirement Plan, you are required to start withdrawing money when you reach 70 1/2. If you don't make the required withdrawal, the penalty is severe. The penalty is 50% of the amount you should have withdrawn. The minimum amount of the required withdrawal is computed based on your life expectancy. If you are 72 years old, the Minimum Distribution Life Expectancy Table says that your life is expectancy is 26.5 years. To compute the required distribution this year, divide the value of your IRA account by 26.5. Of course, you can withdraw more. If your spouse is at least 10 years younger than you, there is a different Distribution Table for you and the required minimum annual distribution is smaller.
10. Use an IRA Retirement Account for Estate Planning
An IRA is particularly useful in estate planning. If your spouse is the sole beneficiary of your IRA, he or she can treat the inherited IRA as their own, so that the IRA continues to earn money tax-free. The beneficiary must start taking minimum distributions based on the date the deceased would have been 70 1/2.
There are many other complex uses of an IRA in estate planning. The important thing to remember is that the beneficiary named on your IRA account will inherit it, no matter what your will says. If no beneficiary is named on the IRA account, the IRA will go to the person named in your will. Thus, it's important that you keep the beneficiary named on your IRA account up to date.
I hope life brings you much success.
The Retirement Coach
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