Monday, January 26, 2009

Learn the lingo: IRA

Ah yes, the IRA, or individual retirement account, another way to reap the benefits of saving early for a lavish retirement!

But wait -- before we go any further -- I know I've probably already lost you. If you're anything like I was at the wee age of 24, your eyes have already glazed over with boredom at the mere sight of the word "IRA," and I don't blame you. Unless you were a finance or business major in college, terms such as IRA were relegated to people like our parents, who are at an age to be concerned with all that stuffy money talk. Right? To put it bluntly, it's very, very relevant to people our age. Sorry to pop your head-in-the-clouds fantasy, but if you're thinking: "I'm only ___ (insert whichever age you are), so I don't have to worry about that stuff yet," then you're dismissing ways to plan for your life that can make you very comfortable (and dare I say rich) in the future.

Guess what? Unless you end up relying on someone else to learn about these things for you and rely on them to carry your deadweight in the future (which I've written about here), it's time to start teaching yourself! What's more attractive than a very stylish girl who's also very financially saavy? Don't worry, IRAs are not, I repeat not, complicated to understand. Cross my heart and kiss my elbow. In fact, they're actually quite simple, like most things in personal finance when you strip away all the technical mumbo-jumbo. Just remember not to feel intimidated by the lingo and the numbers, because if I can understand it (with an English/Journalism background), then you definitely can too.

To strip it down simply, there are many types of IRAs, but people generally choose either the traditional IRA, for any level of income, or the Roth IRA, mainly for people making under $95,000. Both serve the purpose of an "individual retirement account," thus the name "IRA." You can only contribute to an IRA with earned income, so birthday money or Christmas checks don't count, unfortunately.

In a traditional IRA, you can contribute up to $5,000 of your annual income to the account. All money you put into your IRA is sheltered from taxes so, for example, if you put $5,000 into your IRA in one year. That would be $5,000 off your overall income that will not be taxed by the government. When you do decide to pull the money out, though, it will be taxed. And, if you withdraw the money before you're 59 1/2, you'll get charged a 10% fee. The fee acts as a way to curb your temptation of dipping into your budding nest egg; it comes as no surprise that it's highly advised against to pull your money out prematurely.

But what if you want to buy a house -- and the money you've been saving in your IRA would make a nice down payment on a mortgage? Good news! The exception to this 10%-fee rule is if you're using the money to buy a house or pay for higher-ed costs. If you're new to the world of saving and have a rough time saving in general, than having an account that rewards you for saving for the big purchases in your life, like a home, would be perfect for you!

The Roth IRA, though, is an even better match for the fiscally responsible ladies (or gents) out there. Why? Well, unless you're a high-power, corporate executive -- you know, the kind driven around in Lincoln towncars, sipping scotch and balancing million-dollar checkbooks -- you're probably making under $95,000 per year, which is perfect because it's the cutoff point to qualify for a Roth. (You can also make under $110,000 and still qualify, but you'll only be allowed to make "partial" contributions.)

Unlike the traditional IRA, the Roth IRA is not tax-deductible, but you have greater flexibility over your money. In a Roth can withdraw your savings after five years (regardless of how old you are), without being charged a fee. Any interest you accumulate in the account, though, can be taxed. Not making sense? Say after 10 years you have $20,000 saved up of your own money, with $5,000 earned in interest on the money. You can withdraw your $20,000 tax-free, but only have to pay taxes on the $5,000. Not too shabby.

If you're still at a crossroads as to which IRA (traditional or Roth) would be the best for you, a rule of thumb is that the Roth IRA is generally a better bet if you're younger.

Simply put, by saving your money earlier, the younger you start saving, the more you end up with in the long run (with the interest accrued).

It's important to note that an IRA, Roth or otherwise, isn't an investment, per se -- it's just a place to keep a chunk of your savings to use as investing in whatever you choose. That could include bonds, mutual funds, real estate, or even just one stock. Again, an IRA is another way, like the 401(k), that the government is rewarding you for saving for your retirement.

At this point, you're probably asking, "What's the difference between an IRA and a 401(k), then?" I admit, they do sound strikingly similar, but the fundamental difference is that one is employee-sponsored (the 401k, where your contributions are usually matched annually by your employer), while the other (IRA) is completely up to you to create and manage.

Both are fabulous ways to shelter income from taxes, though, so contributing to at least one is in the best interest of every savvy financier!


Julie said...

Great post! I totally agree that women, regardless of age, should be learning about this for themselves. I am married and I handle the finances, so who says you can't be in a relationship and be the financial one. :)

Anonymous said...

How do you open an IRA? Since you said it has to come from earned income, does that mean money put into the IRA must come straight from your paycheck? How do you set that up?

Kate said...

Thanks for sharing this. I just recently started reading your blog but I am really enjoying it. You're right, when I first started reading I did think, "But I'm only 23, I don't need to worry about this." The way you explained it, its really not as complicated as I thought! But I do second Beth's questions (above). Can you do a post on how to get started? Thanks so much!

Crystal said...

Thanks for reading everyone! You guys bring up great questions -- I'll work on an IRA post, Part II to post soon. Thank you for the idea :)

Emilita said...

Such good advice. Middle age creeps up fast on a lot of ill-prepared people, and I'm trying to do my best not to be one of them!

I have another request for potential IRA Part II...once an IRA is set up, can it be changed from traditional to Roth or vice-versa? Also, if you're contributing to a traditional IRA at one job (meaning the money is taken out of your pre-tax paycheck, right?) and switch to another job, how do you make the transition?

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