What is an IRA?

With close to 65% of Americans failing at saving for retirement, perhaps one of the reasons why is that they don’t understand the investment choices that are available. For example, just the other day I had a young investor call me and ask, “Justin, what is an IRA?” Maybe you’ve wondered that very same thing. Well today, we’re examining the details of IRA’s for you.

You may hear the term IRA quite often—which stands for Individual Retirement Account. The basic purpose of an IRA is you to deposit money into an account that is for you in retirement. For example, if I set up an IRA, it would be titled Justin Goodbread’s Individual Retirement Account. Once you deposit the money into the IRA, the money grows tax-deferred.

Here’s an example, let’s say I put $5,000 into the IRA. I make 10% return (since this is a simple calculation to get my point across) on it in that first year or $500 bucks. Because the IRA grows tax-deferred,  I don’t have to claim that $500 of growth when it comes time to report my income on my tax return. Because the growth is not eroded by taxes the IRA can grow more rapidly than an account which pays taxes on the earnings. In my example, in year two, not only am I earning money have my initial $5,000 investment, but the $500 I made in year one is also positioned for earnings. Again, we will say I make another 10%, which means I made $550 this time ($5,000 + $500) x 10%=$550.00). So the money compounds per the investment performance as long as I don’t mess with the principal. When we reach retirement, that $5,000 account—in theory, depending on how you fund it, and how you invested it—could be well worth $300,000, $400,000, or more.

Now, here’s the kicker. There are tons of rules governing IRAs. These governing rules are primarily set forth by the Internal Revenue Service or the IRS. For the purpose of this post, I’m going to focus on the two primary rules you need to know. Remember we’re trying to keep this simple and quite frankly the rules for IRAs can be anything but.

The first rule is there is a maximum amount which you can contribute (deposit). In 2018, that amount is $5,500 per year. Now, another caveat to that is if you are over 50,  there is catch-up provision where you can save $6,500 per year in your IRA as of right now.

The second rule to remember is the IRA is designed for retirement, not as a savings account. Once you put the money in the IRA, you SHOULD NOT withdrawal the funds until you are 59 1/2. This is probably the hardest principle for people to follow. They understand it, but life happens. Their emergency fund is non-existent. They just didn’t plan for whatever it is that comes at them. Now, here they are in their 40s or 50s and decide to grab the money out of their IRA’s. Here’s what instantly happens:

The IRS theoretically says, “you know what, not only are you going to pay taxes on the money that is in your account, but you’re also going to pay a penalty—a 10% penalty—because you broke the rules of the IRA.” Now, because you broke the rules of the IRA, you could be possibly paying 15- 40%  in ordinary income taxes, along with another 10% for your penalty.

Here is where it gets really dangerous; often, the older we get, the more money we potentially earn. So whenever the owner withdrawals money from their IRA, they could end up paying 40-50%, maybe even 60% if they have to throw in state income taxes, from an IRA distribution. Here’s a prime example. I know an individual that wanted to buy a house, and he needed some money for the down payment. So he went in, against the advice of his advisor, pulled out a hundred-and-some-thousand dollars from his IRA. That $100,000 distribution ended up costing him almost $60,000 in taxes and penalties alone! It was crazy!

So remember, as long as you leave the money alone and follow the rules, the IRA grows tax-deferred, hence allowing the account value to grow, grow, grow. If you don’t take the distribution out of the account until you’re 59 1/2, then theoretically, you now have an account with some value in it. When you need income to supplement your other retirement income, you can pull from your IRA.

The premise is when we enter retirement, we may have a little bit of Social Security, along with other retirement assets; however, this retirement account will help subsidize the income you need in your golden years. When you start pulling money out in retirement, you will then pay income tax on the distribution. Many times, your income in retirement will be a lower rate than during your earning years.

There are tons of things you can do with IRAs. Just follow the rules. I’ve only given you two. One being, here’s how much you can put into it; the other is when you can use the money. If you keep those two things in the back of your mind and max out the contribution, it’s a really good planning tool! Talk with your adviser and if you don’t have one, give our team a call. We’ll see if we can help you out.