Traditional IRAs are the original format for the program, and were introduced in 1974. The traditional IRA is designed to shelter income from taxes in order to encourage people to save for their retirement.
How does it shelter income? A couple of ways:
- Tax Deferral: In other words, dividends and other gains that the investments in a traditional IRA earn are not taxed in the year they’re earned. Because they get to stick around untaxed, the account will grow faster. You will have to pay taxes on them upon withdrawal of them, though.
- Tax Deductability: If you meet certain requirements, income invested through an IRA can give you a deduction on your tax return for that year. You’ll pay less in taxes that year!
In a Traditional IRA, all distributions are taxed at your normal tax rate for the year you get the distribution. The only exception to this is if part of the money you contributed didn’t qualify for the tax deduction on the front end. That portion has a “tax basis” already and won’t be taxed again.
The requirements for contributed income to not qualify change from year to year, so I’ll include them in a later post.
Due to the deduction, contributing to a traditional IRA can reduce your taxes while you’re in a high tax bracket. Once you start withdrawing after retirement, those contributions and their earnings are taxed at your normal tax rate for the year you withdraw them…which should be a lot lower, since you’re not earning as much in retirement. Because of this you can get considerable tax savings. Just remember: If you’re under fifty nine and a half you’ll have to pay an extra 10% penalty for withdrawing money from your IRA.
Here’s a short example to illustrate the paragraph above:
You contribute $100 to your traditional IRA at age 40, while you’re in a 28% tax bracket. It qualifies for the deduction, so you pay $28 less in taxes!
At age 70 you withdraw $100 (let’s ignore the gains for this, but they’d be in there too) and pay taxes at your normal rate on the distribution. Now that you’re retired, your tax rate has dropped to 10% and you pay $10 in taxes.
$28 – $10 = $18 of tax savings. You paid 18% less than you might have. That can add up!
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What’s an IRA? For a lot of people, it’s just another confusing acronym the government throws around sometimes. In actuality, it’s an excellent retirement investment tool. So if you’re confused by the whole topic, read along and we’ll see if we can clarify things a bit.
IRA stands for Individual Retirement Account, which is shockingly clear and to the point by governmental standards. In basic terms, an IRA is a tax-deferred retirement savings account. It’s a tool through which you can invest in stocks, bonds, mutual funds, and other assets. Note: An IRA is not an investment itself. Think of it as a garage. The investment is the car inside, but the garage shelters it.
There are actually several types of IRAs, and I’ll go through them one by one in my next mini-series. For reference, though, here’s a list:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
SEP IRAs and SIMPLE IRAs are for self-employed individuals or small business owners, so most people don’t need to worry about them. Traditional and Roth IRAs are much more common, so I’ll address them first.
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When you hear the phrase “saving for retirement,” what you should hear is “investing for retirement.” That’s the attitude you’ve got to have if you want to actually, you know, retire. Sometimes people think they can save for retirement simply by putting money in the bank. Taking the phrase a bit too literally, they just shove their nest egg into a savings account and forget about it. Let’s take a look at what that will get them.
Let’s say Tom goes to the bank and puts $1000 in a savings account so he can retire in 40 years. The savings account earns, say, 1.25% interest annually and he never puts anything else in. In 40 years Tom will have: $1,643.62
But that example was a bit unreasonable. So let’s change it up a bit: this time, Tom’s putting in $1000 every year for 40 years. This time his retirement savings account comes out to: $52,133.18. Hmm…that’s better, certainly. But it’s not going to last him 10-30 years like it needs to.
This savings account thing just isn’t working out so well. Maybe it’s time for Tom to start thinking about his retirement in the frame of investing, rather than just saving. Let’s see how that changes things.
Tom’s gotten wiser. He knows a savings account won’t deliver what he needs, so he turns to a good mutual fund instead. A good mutual fund gives great diversity and is something of a fire-and-forget investment- you don’t need to monitor it constantly. It’s easy enough for anyone to do. So let’s say the mutual fund averages 8% return on investment over the 40 years. For the sake of example, let’s suppose Tom only invested $1000 once, like he did in the very first example. His retirement nest egg comes out to $21,724.52. It’s less than the constant investing with the savings account, but that 6.75% difference in interest rate gave him a $20,080.90 boost over the first example. Not bad. Not bad at all!
Now for the “best case” scenario amongst my four examples: Tom invests $1000 every year for 40 years and the mutual fund averages 8% again. He’ll need a bigger nest, because this retirement nest egg totals $279,781.04. That’s $227,647.86 more than the savings account earned under the same conditions!
I hope this helps you take a new look at retirement. Remember: if you’re reading this, you’re not too young to start planning to retire!
Thanks for reading,
While checking out Lesley Carter’s amazing travel & adventure blog, I found a link she included to a website that grades blogs’ marketing: marketing.grader.com. Curious, I decided to see how I fare. When I plugged in the requested info (nothing more than my blog’s URL and my email address), I got a pretty decent surprise: a score of 78/100.
That seems like a good start to me- at least, given that I’m a busy college student and haven’t had the time to post as much as I’d like. Even better, it offered some great tips on how to improve my blog’s marketing…and didn’t bury me in spam! So I’m going to work on a few things and see where that takes me. I’ve always been a (nearly) straight-A student. So even if a 78’s not bad given my circumstances, I’m shooting for 90+.
Any tips you may have are definitely welcome! The more I look around, the more I realize that this blogging thing is a lot deeper than I expected. I’m looking forward to seeing where it takes me.
Thanks for reading,
Do you ever feel like the news has nothing good to say? I certainly do, as does Mike Maddock in the article that inspired this post. If you have a few minutes, check out the link above for an interesting read.
The first sentence of the article immediately caught my attention: “Some of the most creative people I know decided long ago not to watch TV news.” It stuck out to me because I decided a few years ago to stop watching news on the TV myself. It just seemed so depressing, and the 4-to-1 ratio of commentary to news didn’t help.
I don’t mean to brag about myself there. The real point is that I hope the generally more positive attitude that Mike later notes for people who get off the media train will prove true in my life also. I certainly wouldn’t mind a boost to creativity and/or innovation while I’m at work. Would you?
I think the article hits on a truth: What you choose to bring into yourself has a direct impact on what you express out of yourself. Even the “normal” day-to-day stuff that’s an order of magnitude less horrible than the Sandy Hook massacre is enough to bring down your mood and dull your focus and optimism. That’s going to show through on the job, and if it’s impacting you consistently it’s going to show through consistently.
My recommendation? Find a way to get news in less than 30 seconds. Be informed, but don’t linger to the point that it ruins your day.
When you think about spending a lot of money for a single specific reason, you typically think of two things: your house and car(s). But there are other things that qualify. People around my age often get staggered by the cost of really furnishing a first home or apartment with furniture. People of any age often end up with sticker shock when looking into vacations.
If you’re not planning ahead, these things can cause you all sorts of financial head-aches. Or, worse, they can cause you to punt financially and to choose to go into debt in order to get what you want now rather than waiting for it. Remember this: “Maturity is achieved when a person postpones immediate pleasures for long-term values.” -Joshua Loth Liebman
Saving up ahead of time is always a better way to finance such things, whether they’re furniture or a vacation or something else. You’ll own it outright and you won’t be paying interest on it- interest that can sometimes end up costing more than the thing you purchased!
So how to do this? Set up a savings fund! This doesn’t necessarily mean going to the bank and opening a new savings account for that specific purpose (though you can, if you want). All it needs to be is an envelope, kept in a safe place, into which you put a specific amount of money every month or every paycheck. Do the math and figure out how much you can afford to save each month toward that new couch, a new car, or that nice ski vacation, then save that amount every month until you can buy it.
One last note: if you walk into that car dealership or furniture store and wave a handful of $100s under the salesman’s nose, odds are good you can negotiate a nice discount on the price.
Thanks for reading,
Welcome to Part 2 of my mini-series on savings. Let’s talk about emergency funds. An emergency fund is basically what it sounds like: an amount of money you’ve set aside to cushion the blow on a rainy day. It’s an investment in peace of mind, as compared to an investment in financial growth.
What’s a good emergency fund? To start with, $500-1000 will probably see you through until you get any debt you have under control. Once you’re financially stable, you should build up enough money to cover 3-6 months of expenses. That means you’ll need to know what you spend during the average month. It also means that if you lose your job, for example, you’ll be okay for a few months rather than being plunged into an immediate and severe financial crisis.
An emergency fund can cover you against all sorts of things: lost jobs, medical emergencies, wrecked cars, etc. But there are some things an emergency fund is not supposed to cover. It’s not for a new leather couch or a china cabinet. It’s certainly not for that ski vacation or a trip to the beach. It’s not for shopping sprees. It’s there for emergencies only, and if you don’t respect that it may not be there when you need it.
Resist the urge to invest the money. It’ll be a decent chunk of change, but remember that with investment return comes investment risk. An emergency fund is a safety net, and what’s the use of a risky safety net?
Thanks for reading,