Do you know what your money is invested in?

I actually got the idea to write this when I was sitting down with a senior client, and she could not distinguish between a bank CD and her IRA. Not only did she believe that she owned an IRA and not a CD, but she began to argue with me a bit about the fact that she did not own a CD, just an IRA.

Well...I was dumbfounded. Do the folks at the bank really not explain this stuff? I mean, this woman appeared to have all of her mental faculties about her. She just really didn't understand what she owned.

So...just to make it perfectly clear: When you open an IRA, you'll have to decide whether to open a Traditional IRA or a Roth IRA. Each has its own rules and tax advantages. An IRA is not a product, it's more of an umbrella for taxes. Think of it as an umbrella that houses various types of investments or savings products, like bank CDs or annuities.

Traditional IRA

Congress created the Traditional IRA in 1974. You won't pay taxes on the money you earn from this IRA until you start withdrawing the money from that account in retirement. You may also be able to deduct your annual IRA contributions from your taxable income each year. This will depend on how much money you earn.

The Traditional IRA has several rules governing contributions and withdrawals:

• You can't begin withdrawing money from your IRA until you reach 59½. If you must withdraw money before that time, you'll pay a tax penalty.
• You must start withdrawing money from your IRA when you turn 70½. You'll pay income taxes on any money you withdraw.
• You'll probably want to spread out your withdrawals over several years, that way, you won't get stuck with a burdensome tax bill in any one year.
• If you fail to make withdrawals on schedule, or don't withdraw enough money, you will pay a penalty.
• You can't contribute any more money to your IRA after you reach age 70½.

Roth IRA

The Roth IRA was created in 1997. Only individuals with certain incomes can open a Roth IRA. With this IRA, you will never pay taxes on the income you earn through your IRA investments, as long as your withdrawals comply with IRS rules. This means that your earnings from a Roth IRA grow tax-free over many years.

In addition, these rules apply:

• You can't deduct your annual Roth contributions from your taxable income.
• You can't start using your Roth earnings until you turn 59½.
• You don't have to withdraw money What You Should Know About IRA’s from the account, or pay additional taxes, when you turn 70½.

You can keep contributing money to the IRA for as long as you have earned income.

Traditional or Roth?

At face value, it may seem that the Roth IRA, with its tax-free investment growth and flexible withdrawal policies, is the better deal for a retirement saver. For some investors, this may be true. Economically, the Roth IRA seems to be the better choice for many individuals. But whether a Roth is best for you will depend on how much risk your willing to take and how much control you're willing to hand over to the government. Remember, IRAs, whether traditional or Roth, are government tax favors. They're not private contracts. If you're willing to take the risk that the government will never take that favor away from you-or change the rules so that there is a negative impact on you-then go for it.

If you have any doubts that the IRA will remain exactly the same as it is right now, you might want to consider other, private contract, investment alternatives. Some private contracts are either tax exempt or tax deferred. But, even a private contract, like an annuity or life insurance contract with tax deferred benefits, will offer protections inherent in private contracts that are simply not available with government sponsored programs. Private contracts are often grandfathered against any future changed in tax laws and a private contract can not legally be taken away from you by the government.

Decisions, Decisions

If you make the decision to invest in a bank CD inside of your IRA, make sure you understand what you're getting. A bank CD is a time deposit. The bank takes your deposit and then invests it. It then shares some of the interest with you over time. CDs have maturity dates when the investment matures and you get your investment principal back. Generally speaking, the higher the interest rate paid on a bank CD, the longer you must hold the CD with the bank. All fixed interest bank CDs are guaranteed by the bank and the Federal Deposit Insurance Corporation (FDIC). That's it.

Now, go out there and do your homework and don't go getting yourself confused about the difference between an IRA and a bank CD.

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This entry was posted on December 19th, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Budgeting & Money Management, Investing, Retirement Planning