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Breaking It Down: What Is An IRA?

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Retirement

Breaking It Down: What Is An IRA?

Wondering what an IRA is? An IRA stands for Individual Retirement Account. In layman’s terms, an IRA is an account where you deposit your money and receive favorable treatment from tax authorities.   You have the option of contributing money to an IRA account every year using out-of-pocket funds rather than 401k contributions, which are funded via payroll deductions.

The yearly limit of your contributions in 2017 is $ 5,500.  Also be mindful of the yearly income limits for IRA contributions.  Make sure you check the limits and don’t breach this limit or you will attract penalties and there is no way getting around it as your contributions are reported to the IRS.  In a majority of cases, you have to open an IRA account in your own name. IRA plans have several different forms, but the 2 main forms are:

Traditional IRAs

A traditional IRA helps you by reducing your taxable income if you fall under a specific income limit. As you make your contributions to your IRA with income that has already been taxed, by the end of the year, you can claim a deduction in case you are eligible. After receiving the refund on traditional IRA contributions your money becomes “tax deferred”. This means you will be liable to pay income tax on the earnings and contribution at a marginal rate of tax at the time of taking distributions from the traditional IRA.

Roth IRA

If you make contributions to Roth IRA, this contribution has already been subjected to tax at your marginal tax rate. The benefit is the earnings can be distributed free of tax in case your distributions meet specific eligibility and age criteria.

What’s the difference between a Traditional IRA and a Roth IRA? Which one should you opt for?  The answer depends on various factors, the major ones being:

  • Income – High-income earners who qualify for traditional IRA are better off if they contribute to a traditional IRA, because this enables them to avoid paying tax at their high marginal rate of tax. On the other hand, individuals with lower income will be better suited for a Roth IRA, as they will enjoy a low current marginal tax rate and in return, they will not be taxed on this money in the future.
  • Your Estimated Future Income Tax Rate – Individuals who expect they will end up in the lower income tax slab on retirement are generally in favor of traditional IRAs in case they are eligible for the deduction. In contrast, individuals who expect they will end up in the higher income tax slab on retirement usually opt for a Roth IRA. Lastly, people who contend that income tax rates will rise for everyone in the future tend to go for Roth IRAs.

Your IRA contributions must be invested in funds that your IRA provider offers.

How to Invest Within an IRA

After you have contributed to the IRA, you still have to figure out how to invest within a given plan. This can be a somewhat overwhelming decision for some people. Among the many benefits of the IRA, one stands out: the ability to choose who holds your IRA. If you go for a provider, such as Fidelity, Vanguard or Charles Schwab, you will get the advantage of accessing numerous mutual funds, inexpensive index funds or exchange traded funds where investment can be made without paying fees or commissions.

A nice strategy that will be suitable for most of us is the three-fund portfolio. In this portfolio, your goal is to invest in broadly diversified index funds, which belong to 3 major classes of assets. This includes US stocks, bonds and international stocks. Through investment in three-fund portfolio, you diversify yourself across thousands of securities and lower the risk of underperforming the market. Moreover, you are mathematically sure of outperforming other investors who have adopted a different strategy.

Note that in case you have multiple retirement accounts, consider asset allocation across all these accounts. Precisely identifying a fund’s asset class can be complex and tricky, but in most cases, an IRA provider’s site will identify the asset class of each fund. You can also Google the fund’s name or search for it on a site like Morningstar which gives you a good indication.

Identifying an index fund is even trickier, but generally index funds have lower expense ratios compared to other funds. A fund’s expense ratio is the yearly fee that has to be paid for the privilege of making investment in that fund. Usually a lower expense ratio is the single best indication of better long-term performance. Consider an expense ratio of 1.6 %, it may seem trivial, but compare it with an index fund, which charges as low as 0.3 %. This difference of 1.3 % when compounded over a period of more than 30 years means a loss of tens of thousands of dollars in returns.

It is unfortunate that not all providers of IRA are created equal, and a few IRA providers lack a good mix of low-cost funds for investors to funnel their funds into. If you are in this situation, do not fret. Transferring your IRA from one provider to other only requires filling out and mailing a few forms. In about a month, you will be with your new IRA provider. Visit your provider’s site to know the exact process, but generally, you will only require your personal identification/tax information and a signed consent form authorizing the new IRA provider to manage your IRA.

Asset Allocation

Asset allocation means the manner in which you split your money among different asset classes and a variety of funds in which you have made an investment. Asset allocation is an extensive subject with loads of literature. Here are some basic principles:

  • Your portfolio should be centered on 3 main asset classes, which are US based stock index funds, Bond index funds and international index funds
  • Your age is a good determining factor when deciding the percentage of bonds to hold
  • You should maintain a minimum of 20% of your stock holdings in an international index fund
  • If you are younger, you have the luxury of experimenting with riskier stock funds
  • Change your asset allocation with changing times
  • Target date funds make asset allocation easier for you. These funds become more conservative as a person ages, this reduces your exposure and vulnerability to volatile market movements and trends.

Frequently Asked Questions

  • An IRA has a contribution limit of $5,500, is it possible to make contribution of $5,500 each to both a traditional IRA and a Roth IRA?

The answer is no. The $5,500 limit is an aggregate limit for all your IRA contributions in a particular tax year. For example, if a person has 2 IRAs, he/she may contribute $3,000 to the first IRA and $2,500 to the other. However, you can have multiple IRAs.

  • If I am a person who does not have any requirements to report my earnings to IRS as I am studying in grad school yet earning a stipend, can I make contributions to an IRA?

You can contribute the lower of your earnings or $5,500. People who do not report their earnings do not qualify for IRA contribution.

  • If I intend to retire at an early age, should I contribute to IRA and get my money locked up?

In case you decide to retire before 59, like at 55 years, you may use your distribution to get access to pre tax money without incurring any penalty. If you retire earlier, you may still access it through Roth IRA ladder, but you will have to wait for 5 years.

  • Is it better to pay off debt or contribute to IRA?

IRA contributions do not get priority over 401k contributions, emergency funds and interest based debt. Take care of these obligations before you consider an IRA.

  • I am young and have a high-risk appetite so why invest in bonds?

Bonds are beneficial as they offer a source of funds that enable you to purchase high return investments at a time when they are being offered at a discount during market downturns. They cut down your portfolio’s risk and generally offer a steady stream of income. From a technical perspective, many studies have revealed that people who make all their investment in stocks are usually not compensated strictly in proportion to the risks they have undertaken. Moreover, although stocks outperform bonds in the long run, past performance does not guarantee future returns.

  • Is it possible to get a loan against an IRA?

The answer is no. There are a few 401k plans offering loan options, but you can’t do so in case of an IRA. In case of Roth IRAs, it is possible to withdraw you contribution free of penalty and tax at any time. If you decide to take this course of action, remember that you will be prohibited from replacing the prior year’s contribution.

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