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With so much media attention spotlighting retirement planning these days, you’d think the United States is a nation of hardcore investors, well-versed in the intricacies of all sorts of financial products. But the truth is most Americans know relatively little about one of the most effective tools for securing their financial futures: the Individual Retirement Account.
Indeed, more than 50 percent of Americans don’t even have an IRA, according to Reuters. That may be in part because of a lack of understanding about what an IRA is and how you can use it to help you achieve your financial goals.
Opening up an IRA account enables investors to take advantage of many different investment products, including mutual funds, stocks, bonds, exchange-traded funds and REITs. Virtually any security that can be owned outside an IRA, can be owned inside an IRA.
This is an important to understand because it gives investors the flexibility and latitude to help reach their financial goals, whether they’re short-term or long-term. Knowing what an IRA is can be a good start, but knowing how to use it effectively should be the goal of any investor.
You should take some time to understand the difference between a traditional and a Roth IRA. In short, contributions to Roth IRAs are made with after tax dollars and qualified withdrawals are tax free. By contrast, contributions to traditional IRAs may be tax-deductible, but withdrawals are taxed as ordinary income. Your Adjusted Gross Income and participation in a retirement plan will determine if a traditional IRA is deductible.
In addition, your Adjusted Gross Income will determine if you can contribute to a Roth IRA. You can always contribute to a non-deductible traditional IRA if you do not qualify for a Roth or a deductible traditional IRA. IRA Withdrawals from a traditional IRA if taken before age 59½, may be subject to an additional 10 percent federal tax penalty and possibly state income taxes. Qualified distributions of earnings from a Roth IRA are tax-exempt after five years from the contribution date and after age 59½. Earnings taken before age 59½, may be subject to a 10 percent federal tax penalty and possibly state income taxes.
This is an important distinction because it can guide your decision about which IRA to invest in. In general, younger people (i.e., those under 40) may consider using a Roth IRA. Roth IRAs can often make sense for people over 40 as well, particularly if you believe you’ll be in a higher tax bracket someday.
You’ll be able to pay the tax earlier in life and then reap the benefits of its potential tax-free growth. It’s also important to note that traditional IRAs have required minimum distributions starting at age 70½, while Roth IRAs do not.
Regardless of whether it’s Roth or traditional, a major benefit of an IRA is that you can fill it with just about any type of investment product. In other words, you can find the investment vehicles that match your goals and risk tolerance, from a long-term aggressive to short-term and cautious.
Certainly, a mixture of mutual funds, stocks and bonds within an IRA can help achieve the sort of diversity that most investors seek.
Making the most of an IRA can also mean managing an inherited one appropriately. Indeed, mishandling an inherited IRA is a common – and expensive – mistake. If you are the beneficiary of an IRA, it is important to get competent advice before receiving the money.
Proper titling is crucial, because if you do it incorrectly you (as the beneficiary) may have to distribute the IRA in five years. But if the IRA is titled correctly, you can receive distributions over your lifetime. For example, a custodian may require that an account be titled as follows if it involves a father, John Jones, who dies and leaves an IRA to his son, Sam: John Jones, deceased (date of death), IRA for the benefit of Sam Jones. Titling the account properly enables Sam to take distributions over his lifetime, which can potentially add a lot of value to an IRA by allowing additional growth potential over many years.
Bradley D. Holland is the owner of Holland Financial Group and an investment advisory representative of Lincoln Financial Securities Corporation. He can be reached at 800-774-1806.