Of course, IRA is an acronym that stands for Individual Retirement Account. There are numerous kinds of IRAs that have been created by the United States government to give people incentive to invest for their futures. The names can be confusing and the details can make even a math major’s head spin. But learn to use them right, and they can be the key to a rock-solid financial future.
We’re going to help you skip the confusion and highlight the very best ways to use an IRA to build your personal wealth.
Part of God’s Master Plan for our financial life is to build wealth for the future, and the most common way that we do that in America is to save and invest money for retirement. The days of our employers taking care of us in retirement through defined-benefit pensions are largely behind us, which means that you and I need to come up with solid strategies to build our financial futures on. The Retirement Pyramid gives us a good blueprint for how we should do that.
In the last article in this series, we talked about building a good base for your retirement savings by maxing out your contribution to your company’s retirement plan. These modern plans aren’t as lucrative as yesterday’s defined-benefit pensions, but they still offer a great benefit for investors, because your employer matches the money that you’re investing.
Once you’ve maxed out your company’s retirement match, though, it’s time to turn to another wealth-building tool — the IRA. The idea of an IRA is this: You start a retirement account with an investment firm, and work together with your investment adviser to build a portfolio of mutual funds, stocks and bonds that will meet your retirement objectives. Then, you make contributions to that account every month, and the value of your account grows as the companies that you’ve invested in succeed.
What makes IRAs different than any regular investment account? It’s largely tax incentives. The government wants to encourage Americans to invest for retirement, so it created these special IRAs that people could use to invest without being heavily taxed. If you buy stock on the open market (outside of an IRA), and sell it five years from now at a profit of $1,000, you’re going to have to pay what’s called “capital gains tax” on those earnings. Capital gains tax is currently 15%, which means that you’ll have to give $150 of your $1,000 earnings to the government. But capital gains taxes don’t apply to most IRAs, which can save you a lot of money in the long run.
There are numerous types of IRAs out there, but the best one to start with is what’s called a Roth IRA. Roth IRAs are fantastic opportunities for investors because the tax advantages are very compelling. When you invest in a Roth IRA, you’re investing with “after-tax” money (meaning that you’ve already paid income taxes on the money that you’re using to invest). But decades from now, when you’re ready to retire, your Roth IRA will likely be worth hundreds of thousands — or even millions — of dollars. When you’re ready to start drawing income off of that money, you don’t have to pay taxes on it. That’s the beauty of a Roth IRA — the growth is tax-free!
It’s exactly this tax incentive that makes Roth IRAs better than the 401(k) or similar plan that your company offers. Although your contributions to a company plan are pre-tax (the amount that you contribute is deducted from the amount that you pay annual income taxes on), you will pay taxes on the growth of those plans. And because good retirement accounts swell into six and seven figures, the amount of money that you pay in tax on the back end of a 401(k) amounts to far more than what you saved in tax incentives on the front end.
Roth IRAs, though, save us from paying those back-end taxes. It’s pure profit, simple un-taxed growth, and it’s a beautiful thing. Your company’s retirement plan is only good up to the point that your employer is matching your contributions. After that, though, you should do your additional investing in a Roth IRA, where you can enjoy tax-free growth for the rest of your life.
Of course, there are limits on Roth IRAs that keep people from using them to unfairly dodge taxes. You can only withdraw money from these accounts without paying taxes if you’re old enough to retire. There are maximum limits for how much you can contribute to a Roth IRA each year, and certain people with very high incomes may not be able to contribute to a Roth.
But for the vast majority of American middle class investors, the Roth IRA is the ideal vehicle to drive into the financial future. If you’re ready to begin that journey in earnest, find an investment expert that you trust and ask him to get you started.
Photo by Philip Taylor. Used under Creative Commons License.