316 Chapter 7 Retirement Plans
value calculations we have done in prior chapters can be thought of as retirement account
calculations if we the consider them earmarked for retirement savings. However, there are
a number of special types of retirement accounts available both to individuals on their own
and to workers through their employment that offer special advantages. In this section, we
will take a look at some of the more common types of these accounts.Individual Retirement Accounts (IRAs)
An individual retirement account (IRA) is a special type of account that can be set up by
an individual through almost any bank, brokerage firm, credit union, or other financial
institution. The purpose of an IRA is to allow an individual to save for retirement, and the
tax laws offer significant tax advantages to encourage people to set up and contribute to
these sorts of accounts.
An IRA is not a type of investment in itself; it is a type of account that can contain
almost any sort of investment within it. An IRA is a container that can hold a wide range of
different contents. IRAs can contain ordinary bank accounts, certificates of deposit, stocks,
bonds, mutual funds, as well some other more exotic options. Since the money invested
in an IRA is intended for retirement, it should be invested with that long-term time frame
in mind.
Depending on your income level and a few other factors, you may be able to take an
income tax deduction for contributions made to an IRA. More significantly, the earnings
on money invested in an IRA are not taxed until they are withdrawn from the account. This
tax deferral can be a huge advantage. Gains on investments in an ordinary account are
subject to federal, state, and local income taxes. In order to pay those taxes, money has to
be taken from those accounts, or from some other source. For IRA investments, the taxes
are deferred, so even though taxes will eventually be paid on the investment gains, along
the way funds that would have had to be used to pay taxes are able to continue compound
growth. The earnings on those earnings can provide a larger overall account value than
could otherwise be achieved.
These tax advantages come with strings attached, though. There are limits to how much
an individual can contribute to an IRA in any one year. (The purpose of an IRA is to enable
ordinary people to save for retirement, not to allow multimillionaires to shield huge amounts
of money from taxes.) For 2007, this limit is $4,000 under most circumstances. The limit is
scheduled to increase in future years, though this may change with future changes in the tax
laws. Also, money invested in an IRA can not usually be withdrawn until its owner reaches
age 59^1 ⁄ 2.^2 If you take money out of your IRA sooner, you must pay any income taxes due,
and in addition will normally be subject to a significant additional financial penalty. (There
are some special circumstances where the money can be withdrawn without penalty.) Also,
if you have not already started withdrawing money from your IRA by age 70^1 ⁄ 2 , you must
start to take withdrawals at that time, or face steep financial penalties. The amount you
withdraw each year in retirement must be larger than a certain minimum, calculated on the
basis of your account’s value and your life expectancy—you cannot just leave unlimited
amounts in the account to grow tax-deferred forever.
Roth IRAs are a special type of IRA. They get their name from the late Senator William
Roth of Delaware, who championed their creation. Contributions to a Roth IRA are not tax
deductible, but like ordinary IRAs their investment growth is not taxed while the money
is in the account. Roth IRAs have a unique advantage over ordinary IRAs, though, in that
their investment growth is not taxed when money is withdrawn from the account either.
In other words, all of the investment growth from a Roth IRA is income tax free, not just
income tax deferred. This is a potentially enormous advantage, and recognizing it, Roth
IRAs have become much more popular than ordinary IRAs. The rules for making with-
drawals from a Roth IRA are different (generally more liberal) than the rules for traditional
IRAs as well.(^2) I am not making this up. You can begin to withdrawn money from your IRA on your 59 (^1) / 2 birthday. Right after you
blow out the 59^1 / 2 candles on your cake.