Winter 2010 | Volume 108 | Number 654
The ABCs of IRAs
We spell out the benefits of inidvidual retirement accounts
By Brad Cope
If the recent gyrations of the stock market tempt you to stuff your savings in a mattress, take a word of advice from Cris Moore: Don't. "Even with the ups and downs of the last year and some uncertainty going forward, the stock market has historically generated better returns than a savings account over time," says the Thrivent Financial for Lutherans financial representative in Luck, Wisconsin. "And with fewer companies offering pensions every year, it's crucial to take control of your own retirement."
So where should you put your money? First, contribute enough to your 401(k) to max out your company's matching contribution. Then consider one of the most popular ways to save for retirement: through an individual retirement account (IRA). Finally, talk with your financial representative to see if an IRA should be a part of your savings strategy.
A Basic Definition
In 1974, the government did something smart: It created the IRA. It's basically a savings plan intended for retirement that is usually set up through a financial services company or bank. You have a wide variety of investment options for your savings, including mutual funds, stocks, bonds, annuities and CDs. An IRA allows your money to grow tax-deferred from federal income taxes, which can, over time, make a huge difference in the size of your account when you retire and want to start taking money out of the account.
It's About the Numbers
If that mattress still looks tempting, think again. A key reason for investing in an IRA is the variety of investment options available. Usually, those options are intended to help you earn more than you would elsewhere.
Consider the interest rate on savings accounts at your local bank. You're likely to see a number that falls shy of 1%. Historically, the Standard & Poor's 500 index, a broad measure of the U.S. stock market, has returned an annual average of 9.2%, though this past performance is not a guarantee of what it will do in the future. Similarly, a portfolio of 60% U.S. stocks and 40% U.S. bonds has returned an average of 9.4% from 1970 through 2008, according to Morningstar Principia. The bonds tended to lower the risk of the portfolio while helping to retain its performance.
The numbers become even more compelling when you run them over the course of a career. Imagine twin brothers, Bob and Bill. From age 25 to 35, Bob puts $2,000 a year into a Roth IRA that invests in a U.S. stock mutual fund. Bill waits until age 35 to put $2,000 a year into his Roth IRA and doesn't stop until he turns 65. Both of them earn average annual returns of 7%. Who has more at retirement? Surprisingly, Bob (who only contributed for 10 years) has $225,072, versus Bill with $202,146. That's the power of compound interest – and you can put the same power into your retirement savings, whether you start at 20, 30, 40, 50 or beyond.1
Taxes Are Key
Of course, you could get the benefits of compounding with any vehicle that lets you reinvest earnings. What makes IRAs so attractive are the tax advantages.
"The biggest benefit of the IRA is the tax savings that let you do more with your money," Moore says. "If you invest $5,000 in a traditional IRA and qualify to invest this pre-tax,2 you could save $1,400 in taxes, assuming a 28% tax bracket. If you manage your money closely, that $1,400 in tax savings becomes extra money that you wouldn't normally have – and that you can invest elsewhere for potentially additional returns. And with your IRA, you also can invest in nearly any type of security, where with a 401(k), you can only invest in the options your company allows."
This doesn't mean that an IRA should be your only savings account for retirement. You may want to consider having funds in three types of accounts: tax-advantaged accounts like IRAs and 401(k)s, federal income tax-free accounts like Roth IRAs, and taxable accounts like money market funds that lie outside of retirement vehicles. This strategy may give you maximum flexibility in how you tap into the funds and the tax implications of doing so. Your financial representative and your tax advisor can help you decide which options are appropriate for you.
1 This hypothetical example is for illustrative purposes only. It is not intended to represent the performance of any particular Thrivent Financial product, nor does it take into consideration any investment expenses, such as management fees or sales charges. The results would be reduced if they were included.
2 Your contributions may be tax-deductible if your employer or your spouse's employer doesn't offer a qualified retirement plan and if your adjusted gross income is under a certain level. IRA qualifying gross income levels are subject to change, so it's important to check with the IRS and/or your tax adviser.
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