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The 411 on IRAs

Lesley Scorgie

Posted Sep. 02, 2008
Tagged: Money, MoneyTips, Banking

If you’re looking to invest for the long term, it’s time that you consider setting up an IRA (Individual Retirement Account). If you consult and/or work freelance, this is a must. If you’re employed, consider this as complementary to your 401(k), assuming you’re investing in one. Keep in mind that there are two types of IRAs - the traditional IRA and the Roth IRA. The main difference between the two is in the way you’re taxed when you retire. Here is what you need to know.

The traditional IRA allows you to contribute pre-tax dollars. The tax advantage can appear in one of two ways, depending on how much tax is withheld from your paycheck: a tax refund or a reduced tax bill. The traditional IRA can be very powerful because it reduces your taxable income and, therefore, the taxes you pay. However, when you begin withdrawing the money (you’re required to begin withdrawing it once you reach the age of 70½), you then have to pay taxes on your contributions and on the money you’ve made from your investments.

The Roth IRA is different from the traditional IRA in that you pay income tax on the money you contribute. Therefore, your contributions are not tax deductible. Once you’ve reached 59½ years old, and if your account has been in existence for over five years, you can begin withdrawing your money from a Roth IRA at any time without being taxed. Money grows tax free within the Roth IRA.

Regardless of the type of IRA you choose, the federal government imposes eligibility rules and annual contribution limits that must be considered.

Traditional IRA Requirements

Everyone under age 70½, with earned income, is eligible to contribute. There's no income limit.

Roth IRA Requirements

To be eligible to make a contribution, you must have a modified adjusted gross income (MAGI) that is less than a certain amount, depending on your tax filing status. If you earn less than $101,000 in 2008, you may make a full contribution. If you are married and file jointly, and earn less than $159,000 in 2008, you may also each make a full contribution.

2008 IRA (Traditional & Roth) Contribution Limits

For 2008, the maximum contribution is $5,000 for those aged 49 and below. This limit is slated to increase $500 per year starting in 2009 to account for the effects of inflation.

Choosing between a traditional IRA and a Roth IRA has everything to do with whether you want to pay taxes now or later. To combine the benefits of both plans, try the following: if you’ve got a 401(k) plan at work, use it. Traditional 401k plans allow you to invest with pretax dollars similar to the traditional IRA, and some employers now also offer Roth 401k plans. Your employer might also have a valuable ‘matching’ program that will add to the funds you put in. Pair your 401(k) with a Roth IRA (investing as much as you can up to the $5,000 limit for 2008), because it enables you to save money in the future by paying taxes now rather than later – a balanced approach from a tax perspective.

If you don’t have a 401(k) plan at work, set up both a traditional IRA (pay less tax now, more in the future) and Roth IRA (pay more tax now, less tax in the future) to balance your investment. Contribute as much as you can to both, up to a combined total contribution for the year of 5,000.

If you’re ready to open an IRA, look for a financial services provider that you trust and that offers convenient services. It’s likely that your current bank or brokerage firm offers IRA accounts.

Check out the following sites for additional information on the traditional IRA, Roth IRA, and 401(k) plans:

http://www.irs.gov/retirement/index.html
www.bloomberg.com
http://finance.yahoo.com
www.richbythirty.com

Happy Investing!
Lesley

Lesley Scorgie is the bestselling author of Rich by Thirty: A Young Adult’s Guide To Financial Success published in January 2007 and printed in English, French and Korean. Lesley owns and operates Rich By Inc., a financial consulting company dedicated to providing education, resources and tools for a variety of demographics. Lesley’s passion is to encourage financial literacy, a topic she has enthusiastically promoted through speaking and writing since 2001.

She has made numerous television appearances including The Oprah Winfrey Show and Montel Williams, and her financial writing has appeared in publications such as Unlimited magazine, the Calgary Herald and the Calgary Sun. Lesley has worked in the banking and securities industries and as a spokesperson for Canada Savings Bonds.

In 2005, Lesley Scorgie graduated from the University of Alberta with a Bachelor of Commerce degree in marketing and finance. She currently works diligently to promote financial literacy through speaking, educating and writing. In addition to this Lesley dedicates substantial time, energy and resources to non-profits within her community. See Lesley Scorgie's other posts and profile.

Qvisory's educational content is supported in part by the Qvisory Education Fund.

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3 Comments

Jason Simon
10/10/08 12:02 PM

The following is a great post about Roth IRA's from Broke Grad Student:
http://www.brokegradstudent.com/college-student...

Lesley Scorgie
09/08/08 04:45 PM

Maximizing your contributions is an excellent idea. Not only do you receive a matching portion from your employer, but you’re money will grow much faster through the power of compound interest. The Weakonomist is right, every situation is unique. Take a few moments to chat with a professional advisor to determine what ‘split’ of contributions you should make between your 401 (k) and Roth IRA.

the weakonomist
09/03/08 07:05 AM

A good rule of thumb is contribute to the 401(k) up the maximum your employer matches. Then whatever is leftover put in a Roth IRA. This is assuming of course that you make no money like me. That matching contribution is free money, take it even if you put it in a money market fund.

So if my employer (a bank) offers a match on the first 8% of my contributions, I'll contribute 8% of my check to the 401(k) and whatever I have left goes to the Roth. In this case I save 15% so 7% goes to my Roth.

Its only a rule of thumb, your situation may be unique. If you don't know what you're doing, always talk to someone who does. Bloggers like me know a thing or two and Qvisory members benefit from the great resources here. 2nd, 3rd, and 4th opinions are encouraged.