Despite the many financial benefits of Individual Retirement Accounts, for most Americans these investment vehicles are an afterthought when it comes to preparing for retirement.
According to a TIAA-CREF survey out this week, only 18 percent of Americans contribute to an IRA as a part of their retirement saving strategy. When asked to rank their priorities in terms of how and where to allocate their savings, contributing to an IRA ranked behind putting money away for short-term goals, such as vacations or buying appliances.
What do people see as their top priorities? Saving for a house or college ranked first, while No. 2 was saving through an employer’s retirement plan, according to the investment firm.
In short, the survey makes clear that IRAs are widely underutilized as a retirement savings tool. Indeed, 43 percent of respondents didn’t even seem to know what an IRA is, while 39 percent said they don’t know enough about the accounts to consider one.
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Among people who do have an IRA, 53 percent indicated they do not have an employer-sponsored retirement plan, up from 38 percent in 2014. One reason could be that as the economy evolves, more workers opt for self-employment in new industries, such as the so-called sharing economy or to work for a startup, where there are often no employer benefits.
Therefore, for a growing number of workers, having and contributing to an IRA is more important.
Given the many types of IRAs and various rules on the limits and deductibility of contributions, it’s not all that surprising that there’s some confusion out there. To that end, here are some of the main types IRAs, along with a description of how they work and when they should be considered.
Traditional IRA: This type of IRA, also called a Contributory IRA, allows for the IRA owner to make additional contributions each year. The contributions are limited to $5,500 per year and an additional catch-up contribution is allowed for IRA owners who are age 50 or older.
Contributions may be allowed to be taken as an adjustment to income as long as the IRA owner has earnings from working that year. The wrinkle in that is that if the IRA owner is also a participant in an employer’s retirement plan, then the tax break for contributions is limited when income exceeds $61,000 for singles ($98,000 for married) and is barred when income exceeds $71,000 and $118,000 (married). The tax deduction may also be allowed for contributions to a spouse’s IRA, where the household income is less than $193,000.
This type of IRA is ideal for folks who are not able to contribute to an employer’s retirement plan (because they’re not eligible to join a plan or no plan is offered, for instance), want to save for retirement and can benefit from the tax deduction for contributions. In fact, if you’ve just prepared your 2014 tax return, you can still make a tax deductible contribution to your IRA by April 15, which can be claimed on your 2014 tax return.
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Roth IRA: This type of IRA allows for the same contribution limits as traditional IRAs. The big difference with a Roth IRA is that while there is no tax deduction for contributions, all withdrawals properly taken from the account after retirement are completely tax free. Another benefit is that there is no requirement to take minimum distributions from a Roth IRA after age 70.
Because of these advantages, this is the best IRA option for folks as long as they plan to leave money in the account for at least 15 or 20 years. This long-term investment horizon allows plenty of tax-free growth.
An ideal strategy for using a Roth IRA is to first make contributions to your employer’s retirement plans up to the matching limit, and then contribute the additional $5,500 (or $6,500) to the Roth. After you’ve maxed out your Roth IRA, if you still have more cash flow to save, then go back and increase your contributions to your employer’s plan above the matching level. You can also use the Roth account in lieu of a traditional IRA, where the time horizon for use of the Roth assets is long term.
Rollover IRA: This IRA has a special purpose, which is to receive direct transfers from your prior employer’s retirement plan. When you direct a distribution from your employer’s retirement plan to be paid to you, federal law requires the plan to automatically withhold 20 percent towards taxes from your distribution.
If you decide to then roll over your distribution to an IRA, you have 60 days to do it. You’ll also have to come up with the taxes withheld by using your other funds to make a rollover of the full amount withdrawn from your plan. To avoid this complication, you simply open a rollover IRA and have the retirement plan directly pay the distribution to the IRA and not to you.
According to TIAA-CREF, 30 percent of those polled said they left assets in one or more 401(k) or other retirement plans with their employer. Rather than scatter your savings around several former employer plans, it’s typically better to consolidate you savings into a single rollover IRA. That will make it easier to monitor and manage your retirement assets.
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