How often have you heard statements similar the following?
"Because of what's going on in the market, I'm staying away from an I.R.A." Or, "The bank is not paying enough interest to even consider locking up my money in an I.R.A."
In the first case, the individual's concern about the stock market is a common misconception that an I.R.A. is automatically tied to the market. The truth is that an I.R.A. is just another type of bank or investment account except that it has special tax savings perks. And, the owner of the account may choose almost any type of investment ranging from F.D.I.C. insured deposit accounts to stocks and bonds.
An investor with very low tolerance for risk can put money in an I.R.A. and still stay out of the stock market. It is important to carefully choose the advisor or institution where you want to keep your account. However, many people do not realize that I.R.A. funds can be rolled over from one place to another as the owner chooses or as their investment needs change.
The second statement regarding interest rates stems from the idea that the key incentive to invest in an I.R.A is based on what kind of interest rate return you can get. This is also a misconception. Because the ability to earn interest inside or outside of an I.R.A. is generally the same regardless of weather or not rates go up or down, the real reason to route contributions into an I.R.A. is to take advantage of the tax savings.
I think these savings can be far more significant than most people realize!
For the I.R.A. type known as "traditional," there are two primary tax incentives.
First, annual contributions (up to $5,000 in 2010 per individual plus another $1,000 for those who are age 50 or older) are deducted from your taxable income.
Secondly, the earnings from the account are not taxed along the way.
For example, let's consider an individual who is 35 years old and has a federal and state combined tax bracket that is twenty percent. If they contribute $2,400 into an I.R.A. each year through age 64 and the account only earns 2 percent annual interest, they will still have saved $24,946 in taxes by age 65! Higher earning interest rates only increase this savings.
Keep in mind though that subsequent retirement withdrawals from an I.R.A. are taxable, but only as they are withdrawn.
For those concerned about paying taxes on their retirement withdrawals, a Roth I.R.A. may be a better fit. With a Roth, contributions are not deductible; however, the earnings are not taxed along the way and the retirement withdrawals are not taxed either.
For the same individual mentioned above who is investing $2,400 a year, they will still save $6,355 in taxes investing into a Roth I.R.A. by age 65, and their future retirement withdrawals will be tax-free.
There are income limits and exceptions that need to be considered when contributing to an I.R.A. Also, there are tax credits that can kick in for whose income levels qualify. Most banking institutions and financial advisors employ experts that are well-versed with these rules.
Before directing money into an I.R.A. it is advisable to check your employer-provided retirement plans to make sure you are taking advantage of company match dollars. These employer-matching contributions can be powerful tax-free (they are even free of Social Security and Medicare tax) account builders, and they can provide a cushion in your account that works to help offset market fluctuations.
After dispelling these myths, it is clear that an I.R.A. can be placed in an investment that matches your investment style, and the tax benefits can make that investment more rewarding. The key ingredient towards a truly successful I.R.A. contribution plan is to establish a dedicated and consistent funding plan.
Often, making this plan as automatic as possible is the best.
Consider whether or not your employer's payroll department can direct deposit portions of your net pay to your I.R.A. account like they may already be able to do with your checking or savings account. If not, perhaps your financial institution or investment advisor can set up automatic withdrawals from your checking account.
And finally, remember that when cash flow is tight, it is better to a establish smaller, more systematic funding program than it is to put a hold on the plan hoping larger contributions can be made later in the year.