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Personal Finance

Simplify Your Life With an IRA

By Brenda W. Newmann
Senior Editor, mPower

  1. Tax-deferred savings
  2. Tax deductible contributions possible (traditional IRA)
  3. Tax-free earnings possible (Roth IRA)
  4. Easy access to your money
  5. Range of investment options
  6. Control over your investments
  7. Social Security won't be enough
  8. Estate planning possibilities
  9. Dollar-cost averaging possible

In the Philadelphia area, there lives a man who has a traditional IRA, three separate 401(k)s, some taxable accounts, and a quarterly nightmare in his mailbox.

"Diversification is great until the mail arrives and you've got 10 different statements," says the 39-year-old mechanical engineer, who asked not to have his name printed. (We'll call him Joe Smith.)

Smith is considering rolling over the three 401(k)s, all from previous employers and worth about $180,000 in total, into a single IRA in order to simplify his life. He also wants to have more control over his money.

Currently between job opportunities, Smith says he may also wait to see whether his new employer has an attractive 401(k) plan to roll his other 401(k)s into. "The main thing I am looking for is being able to consolidate everything in one place."

Ask three different people why they have an IRA and you could get three different answers -- there are the potential tax advantages, of course, but there is also the flexibility in investments and in accessing your money, and the possibility of building up a substantial balance through interest compounding.

"An IRA is one of the best ways the government has ever given us to save for the future."
- Bob Skomars,
IRA expert

In short, "an IRA is one of the best ways the government has ever given us to save for the future," says IRA expert Bob Skomars, a consultant with Universal Pensions, Inc.

But there are also a lot of rules that can affect the options available to you.

"There are so many different regulations," said Elizabeth Allen, a certified financial planner in Michigan. "No wonder it's a nightmare for individuals to figure them out!"

That's why it is important to arm yourself with information, she said, and think about seeking advice from a financial professional before making a decision on your own situation.

To get you started, here's a look at some advantages of investing in an IRA.

1) Tax-deferred savings

In all IRAs, you benefit from compounding of your tax-deferred savings. In effect, your untaxed interest stays in your account and earns even more interest. This allows for bigger growth of your account.

For example, if you invested $2,000 a year in a tax-deferred account beginning at age 25 and continuing each year for 40 years, assuming a 10% rate of return you would end up with $974,384. Only $80,000 of that would have come from your contributions -- the rest would be from compounded returns.

2) Potential for tax deduction (traditional IRA) A lot of people mistakenly think that nobody can take a tax deduction for their contributions to a traditional IRA. Congress did slap on tight limits in 1987, but tax deductible contributions are still possible if you meet the requirements. If your employer doesn't offer a 401(k) or other employer-sponsored retirement plan, you can make tax-deductible contributions to a traditional IRA no matter what your income. True, the annual maximum contribution is $2,000, but if that is your only option, you should grab it.

"The conventional wisdom says take advantage of tax breaks when they are available!" said Skomars.

If you are an active participant in an employer-sponsored retirement plan such as a 401(k), you can still contribute to a traditional IRA but you may not be able to deduct the contributions if your income is over a certain limit.

3) Potential for tax-free earnings (Roth IRA)

With a Roth IRA your contributions are not deductible; they are made after taxes. However, if you meet the conditions you will be able to withdraw your money tax-free even before you retire. You benefit from compound interest that is never taxed - not even when you withdraw it - if you follow the rules. For a summary of rules click here.

4) Easy access to your money You can always withdraw money from your traditional or Roth IRA. Under certain circumstances you might have to pay a penalty for early withdrawal. However, there are a number of exceptions including the ability to withdraw up to $10,000 to purchase a home, and the ability to pay college costs for a family member. 401(k) plans aren't as flexible.

5) Potentially wide range of investment options.

When you invest in an IRA, your investment options encompass whatever your financial institution offers. This can be mutual funds, individual stocks or bonds, CDs, etc. You can tailor your account to your preferences. You are not limited to what your employer chooses for the plan.

6) Control and consolidation of investments

If you leave a company where you participated in a 401(k) or similar plan, you can bring the money under your control and keep the tax advantage if you roll it into a traditional IRA. This may be particularly reassuring if your company's future is uncertain. Joe Smith above, for example, said that one of the reasons he wanted to move his money into an IRA was that his former companies were small and faced uncertain futures.

When rolling money from a 401(k) or similar plan into an IRA, it is important to be aware of the rules. One thing many people do not realize is that they can roll money from their employer-sponsored plan into a traditional IRA called a "conduit IRA," and later -- even years later -- roll that money back into a new employer-sponsored retirement plan. However, if you contribute any extra money to this conduit IRA you immediately lose the ability to roll it over into an employer-sponsored plan later.

Elizabeth Allen, the certified financial planner, tells her clients to be particularly careful on this last point.

"I had a client whose 401(k) was just under $1,000, so he 'rounded it up' by adding some money when he rolled it over into an IRA," Ms. Allen said. "Nobody at his bank told him that this would prevent him from eventually rolling it back into his new company's 401(k) plan down the line."

7) Social Security won't be enough IRAs belong to the third leg of the retirement stool -- personal savings. (The other two legs are employer-sponsored retirement plans and Social Security.) It is generally recognized that you'll need all three legs in order to have adequate retirement income.

Many people who participate in an employer-sponsored retirement plan mistakenly believe that this prevents them from contributing to an IRA as well. It doesn't.

Depending on your income level, you may still be able to make deductible contributions to a traditional IRA, or open a Roth IRA. If neither option is open to you, you can still make non-deductible contributions to a traditional IRA.

Some financial planners suggest contributing enough to your 401(k) plan to get the full employer match, then contributing to a Roth IRA to get the possibility of tax-free income when you withdraw the money. It is a good idea to seek professional guidance when deciding how to divvy up your investments.

"I had a client whose 401(k) was just under $1,000, so he 'rounded it up' by adding some money when he rolled it over into an IRA. Nobody at his bank told him that this would prevent him from eventually rolling it back into his new company's 401(k) plan down the line."
- Elizabeth Allen,
Certified Financial Planner

8) Estate planning possibilities You may be able to plan your estate so that your heirs continue to benefit from the tax advantages of your IRA. Check with an estate-planning professional for details.

9) Dollar-cost averaging You can set up your IRA to receive automatic payroll deductions. This ensures that you contribute regularly, and therefore you can benefit from dollar-cost averaging (investing an equal amount of money at regular intervals, so that you buy more shares during market downturns and fewer shares during market upturns).

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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