Planning For Retirement – Part 2 … Individual Retirement Accounts (IRA’s)

Basic Information

The creation of Individual Retirement Accounts was included in the Employment Retirement Income Security Act (ERISA) of 1974.  This law empowered individuals to create their own retirement program by contributing money (at that time, the maximum contribution was $1,500) into a special account that would grow on a tax-deferred basis; and, the contribution to this account would reduce the individual’s taxable income for the year in which it was made.  Tax-deferred growth was, and continues to be, one of the greatest advantages offered by an IRA.

Originally, these plans were restricted; meaning, only those people who did not have any type of employer sponsored retirement plan could participate.  But, over the past 37 years, numerous changes have been made to the IRA.  Today’s IRA can be used by any individual; but, there are qualifications that determine how the plan can be used to reduce taxable income.  To see how the plan works, we’ll examine several different scenarios.

Janice works for an employer that provides no retirement plan of any sort to its employees.  Because Janice has no access to a qualified retirement plan, she can contribute up to $5,000 to her IRA and her full contribution can be deducted from her taxable income.  Thus, if Janice makes $40,000 this year and she contributes the maximum amount into her IRA, she will immediately reduce her taxable income to $35,000.

Todd has a qualified retirement plan available to him through his employer.  Because he is eligible to participate in this plan, Todd has some restrictions on tax deductibility of his IRA contributions.  If Todd’s modified adjusted gross income (MAGI) is less than $58,000, any contributions he makes into an IRA will be fully deductible.  If his MAGI is over $68,000, his contributions will not be deductible.  If MAGI is between these two amounts, his contributions will only be partially deductible.

Loren is 60 years old.  Because he is over 50 years of age, the law allows him to contribute up to an additional $1,000 to his IRA under what is referred to as the “catch-up” provision.  The deductibility of this additional contribution is subject to the same standards as both Janice and Todd.

The limits to modified adjusted gross income for married couples are higher; and, the availability of a qualified retirement plan to both or either person will impact the deductibility of the contributions.

The Advantage of Tax-Deferred Growth

Let’s assume that Josh invests $5,000 into his IRA every year, beginning at age 35.  After 30 years, Josh is age 65 and has made a total investment of $150,000.  We’ll also assume that he earns the same 8% return on his investments every year.  Finally, we’ll acknowledge that Josh is in the 25% marginal tax bracket.  Let’s see how his money would grow.

Total Contribution IRA Value Non-IRA Value
$150,000 611,729.34 $314,256.29

Now, let’s assume that, at age 65, Josh takes all of the money from his account in one lump sum.  How will taxes impact his retirement?

Total Contribution IRA Value Non-IRA Value
$150,000 611,729.34 $314,256.29
Taxes Owed on Withdrawn Amount $152,932.34 0
Total Spendable Funds $458,797.01 $314,256.29

Obviously, I think that we will agree that Josh is better off with the after-tax value of his IRA than he would have been had his account been subject to taxation for the entire 30 year period!  You can use a number of different financial calculators that are available on-line to see the advantages of tax deferral in your own specific circumstances.

Withdrawal of Money

As shown above, funds in an IRA are subject to federal income tax when withdrawn from the account at or after age 65.  But, if those funds are withdrawn before age 65, the proceeds are not only subject to income taxation, a 10% penalty will also be collected for a “pre-mature” withdrawal!  While there are some circumstances under which the 10% penalty will be waived, clearly, these accounts are intended to be left untouched until retirement.

Next up … ROTH-IRA’s

Comments

  1. Soledad W. says:

    I truly enjoy this site, it contains good articles.