In Focus

Grandma Knows Best, and IRA's Are It!

While working the crossword puzzle this morning, thirty-seven down said "a savings plan." It was three letters long; middle letter was "R". It came to me quickly -- IRA. I've been working with IRA'S for many years now. I think they are a good deal and feel that everyone should know at least enough about them to decide if they are a good deal for them.

So, what is an IRA? The initials stand for Individual Retirement Account (not Irish Republic Army -- at least not in this article). Why should I think about retirement now, you may wonder. Doesn't everyone have a 401K through his or her employer? Or a pension of some sort? And there's always social security, isn't there? Well, let me tell you, not all working people are covered by an adequate pension or 401K. Even if they are covered by social security, there will not be enough money at retirement time for them to maintain the same standard of living they enjoyed while they were working. When the social security system first began in 1935, it was intended to completely take care of a family during their retirement or non-working years.

It wasn't long before it proved to be not quite enough;  people were living much longer and costs of living were increasing beyond social security withholding increases. So employers began setting up pension plans for their employees. By 1986, this also was proving not to be adequate for living "the good life" after retirement. So, again, the government took over and initiated the IRA plans. There are actually two different types of IRA's: the traditional IRA established in 1986 and the Roth IRA newly established in 1998. Let me tell you just a little about each one.

The Traditional IRA
In order to establish and contribute to a traditional IRA, the individual must have some taxable compensation. Basically that means income from work done for an employer or as a self-employed individual. So, you ask, why not just put money in a savings account at a bank and save that for retirement? In a word: taxes. There is definitely a tax advantage for you to put that money in an IRA vs. a regular savings account. If you qualify (and for the moment, let's assume you do) you can put money (maximum of $2000 per year) into a traditional IRA and pay no tax on that money the year you put it in. Then later in life, preferable after age 59, you can take it out and pay tax on it then.

So what's the big deal? If you are going to pay tax on it anyway, why wait until you retire? As I tell my tax classes, a dollar you have today is much more valuable than a dollar you have years from now! Think a bit. By not paying tax this year on $2000, perhaps you save $600 in federal and state tax. Invest that $600 this year and even if it's only at, lets say 6% interest rate, after 30 years that $600 will be worth over $3250. So, let's assume you are at the same tax rate then as you were when you contributed it to the IRA, you will pay out $975 in taxes. So, net result, you have $2275 more money in your pocket! Figures can vary, but the result is always in your favor. There are a lot of other details to consider when putting money into a traditional IRA, but I am leaving that for your tax advisor to explain to you.

The Roth IRA
Conceived by Senator William Roth as a new way to encourage retirement savings. Many of the rules that pertain to traditional IRA's are the same for Roths (must be working, $2000 maximum, etc.). The main difference between a traditional IRA and a Roth IRA is that contributions to a Roth IRA are never deductible but the distribution (that's when you take out the money) is entirely exempt from tax. In the previous example, put that $2000 in a Roth, take it out thirty years later and you are $2650 ahead. Make sense?

Both of these IRA's are something all working people should think about; review the options with your tax specialist to see what is the best for you. Roth IRA's favor younger taxpayers who have a longer period before retirement. They also favor taxpayers who expect to be in a significantly higher tax bracket when distributions begin. A deductible traditional IRA is generally the better choice for taxpayers expecting to be in a significantly lower tax bracket when they take it out.

One more IRA to mention is the Education IRA. This allows taxpayers to save for higher education and save tax dollars in the bargain. Contributions are limited to $500 yearly for each beneficiary (the person who would take advantage of the higher education), and not deductible by the person contributing. However, they are completely tax free when the designated student takes it out to pay for college expenses. I do this for some of my grandchildren on their birthdays and Christmas. That is, I put some money in their previously established Education IRA. The real young ones -- up to five years old -- are happy with a wrapped $5.00 gift in addition. On the other hand, the children ages six to fifteen think grandma is stingy with that $5.00 gift. The children ages sixteen to eighteen are thrilled to see their college money grow.

But Grandma knows what is best for all!