IRA Breakdown

A lot of you probably have an IRA. You might even have two -- for example, a traditional and a Roth. You probably know that in general, IRAs, or individual retirement accounts, are investment vehicles geared for your golden years. But do you know the different types? And are you sure the one you have is best suited for your needs?

There are actually four different types of IRAS: traditional, Roth, SEP and SIMPLE. The traditional IRA allows the investor to contribute pre-tax income (this is good -- it lowers your taxable income) to an account that will grow over time. For example, Mary, who makes $80k, will first contribute $5k to her IRA, and then pay her taxes based on an income of $75k.

The current contribution limit is $5000 for those 49 years of age and younger, and $6000 for those 50 and over. In addition to the tax benefit, the contributions and their earnings grow tax-deferred over time. (This means you won't pay any capital gains nor dividend income tax.) When you do reach retirement and decide to start withdrawing, the money will be treated as income and you'll be taxed. The hope/plan is that you'll be in a lower tax bracket and therefore pay less taxes in those golden years than you would have while working. The other benefit is that of compounding -- there's more to grow over time since taxes aren't being removed from the pool of money.

A Roth IRA is similar in that if offers a haven for retirement earnings, but different in that
it may not be funded with pre-tax income. So if the same Mary from the previous example makes $55k after taxes, her ROTH contribution will come from the $55k. The benefit is that she'll receive the distributions free of tax since she already paid taxes on her earned income before contributing. However, there are income limits for a Roth. If Mary takes a better job and her adjusted gross income rises to $111k, the amount she can contribute is reduced. If her AGI rises to $116k, she is no longer eligible. (Don't get me started on this one -- there is of course no adjustment by the good ole USG for cost of living -- the "rich" woman in New York making $116k is not eligible, but her friend with a $90k salary in Topeka, KS, can contribute.)

SEPS and SIMPLE IRAs are established by employers, usually small businesses. A SEP is a simplified employee pension where the even a sole proprietor can contribute 25% of her net earnings (or $45,000 -- whichever is less). They feature low administrative costs and flexibility -- if a new business has uneven cash flow and doesn't contribute one year, that's okay (although not advised). The earnings grow tax deferred until you start making withdrawals, similar to the traditional IRA.

SIMPLE stands for savings incentive match plan for employees. The employer gets a tax deduction for contributions made and can either elect a flat rate or match a percentage of the employee's contribution. Like with SEPs, the earnings grow tax deferred.

A few final nuggets:
1. The IRS is always changing the contribution limits -- they like to keep everyone on her toes!

2. If you have a 401(k) plan, this doesn't mean you can't contribute to an IRA! In a perfect world, you'd max out both.

3. Malbec is a fabulous wine with which to learn about IRAs. I just tried (and bought a case of) Dona Paula, a delicious chocolaty, raspberry and full flavored wine perfect for crisp fall nights.