This is the busy season for Individual Retirement Accounts.
With April 15 looming, IRAs come into focus not just as a good way to accumulate long-term investment dollars but as one of the few means to shave taxes after the tax year is over.
Unlike with the majority of deductions that expired when the clock struck midnight on New Year's Eve, IRAs offer a potential tax break , for 2012, that still can be taken by April 15 of this year. That investment deadline to fund an IRA remains at April 15, even if you seek a six-month extension to file your income-tax return.
Some people are getting the message: Fidelity Investments reports that roughly 45% of all annual IRA contributions it receives come during the four weeks leading up to the mid-April tax deadline.
But the appeal of IRAs remains lost on many Americans. Eighty percent of adults surveyed recently by TIAA-CREFCQ said they won't contribute to an IRA this year, up from 76% last year. That's despite the fact most people with job-related income can qualify for some type of IRA.
Those results might even overstate the situation. Only about 15% of households actually contributed to an IRA in each of the past half-dozen years, according to a recent Investment Company Institute study.
"A lot of people just aren't aware of IRAs, and there are questions of complexity," said Joel Dickson, a principal at the Vanguard Group in Valley Forge, Pa., during a recent stop in Phoenix. "But contributing to an IRA greatly increases your retirement viability down the road."
To the extent Americans are underutilizing IRAs, confusing rules are partly to blame. Learning about the accounts isn't easy, as there are restrictions on eligibility, contribution amounts and penalties. As a general rule, withdrawals taken before age 59 1/2 are subject to a 10% tax penalty.
And for many individuals, a lack of money to invest creates another hurdle. "People see it as a cash-flow hit, especially those living paycheck to paycheck," Dickson said.
In truth, a lack of ready cash isn't necessarily a good excuse for not investing in an IRA, because of the retirement-savings credit. This tax break provides up to $1,000 in government matching funds for singles, $2,000 for married couples, in the form of a federal credit. Eligibility is restricted to moderate-income individuals — singles with up to $28,750 in earnings can qualify for at least a partial credit for 2012, as can couples earning as much as $57,500. (The 2013 thresholds are slightly higher.)
Still, many people don't have enough money to invest both in an IRA and a workplace plan such as a 401(k) account. If your employer offers matching funds on the latter, you should favor the 401(k), Dickson suggested.
Investing in an IRA or any other retirement account also means delayed gratification — you can't spend the money now. Early retirement penalties and other obstacles are designed to discourage people from tapping into their accounts prematurely. IRAs work best when you give them decades to grow on a tax-sheltered basis.
Among other impediments, IRAs aren't open to everyone. One key rule requires that you have earned income, meaning taxable compensation, to be eligible to make contributions. That eliminates many retirees and youngsters.
Tax deferral is the common thread that unites the two most popular types of IRAs. With both traditional and Roth accounts, the money you contribute compounds tax-free for as long as it remains in the account. Both main types of IRAs also allow the same contribution amounts — up to $5,000 per person in 2012, rising to $5,500 this year. People 50 and older can add another $1,000 each year, although the ICI study found relatively few people make "catch-up" contributions.
That's about where the key similarities end, as other key provisions vary greatly between Roths and traditional IRAs.
In particular, money withdrawn from Roth IRAs can be taken out tax-free as long as you retain the account for a minimum amount of time (typically at least five years and past age 59 1/2, although there are exceptions). The tax-free feature makes them enticing to people who think federal tax rates will rise in the future, or who suspect their own income will rise substantially in the years ahead. In contrast, withdrawals made from traditional IRAs are taxable.
The flip side is that traditional IRAs offer a better deal on the front end. You might be able to deduct contributions made to a traditional account, depending on your income and whether you have retirement coverage at work. Investments in Roths aren't deductible.
Young adults just beginning their careers probably should be gravitating toward Roths, especially if their income falls in a low-tax bracket. "If you're in the 15% bracket, the value of the deduction just isn't that much," said Dickson. Plus, those investors can look forward to decades of tax-deferred growth, along with tax-free withdrawals at the end.
Fidelity found that 86% of all contributions made by investors in their 20s went into Roths. That was nearly double the proportion of Roth investments made by Fidelity customers in their 60s.
One underappreciated aspect of Roth IRAs is that you can withdraw your original contributions, at any time, without facing taxes or penalties. This is considered a return of your original investment and can be good for people who worry about not having access to their account, said Dickson, though he encourages investors to leave their money alone for as long as possible.
Both main types of IRAs have merits and drawbacks, so it can make sense to have both types, especially in terms of providing withdrawal flexibility. For example, you could choose to withdraw from a traditional account during years when you don't have a lot of other taxable income, and you could opt to pull money from a Roth during years when you do.
In fact, you are allowed to convert or switch from a traditional IRA into a Roth — in effect, transferring money from the former into the latter and paying any taxes owed. While there are income limits that prevent high-income people from investing in Roths, everyone is eligible to convert as long as he or she is willing to incur the tax bite.
"The prior income limit of $100,000 was permanently repealed beginning in 2010," wrote Ed Slott, a certified public accountant and IRA expert in suburban New York City. "Therefore, there is no income limit for a Roth IRA conversion in 2013."
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USCCU pays a bonus rate on all certificates over $50,000. IRS penalties may apply for premature withdrawals in addition to an early withdrawal penalty. Please consult your tax professional for more information.
*For more details please refer to your IRA plan agreement and disclosure. IRS penalties may apply for premature withdrawals in addition to an early withdrawal penalty. Please consult your tax professional for more information.
Source: Russ Wiles, USA Today