What is IRA, A Beginners Guide to Traditional IRA

This write-up is for the beginners and the young adults. This is also for the people who just arrived from over seas to work in United States. It took me 3 year upon arrival in this country, to understand IRA concept fully, or understand up to an extent where I can take informed decisions.

The best place to learn about IRA is from the horse’s mouth, that is from IRS website.

But, if you are a beginner, you probably are facing the same issue I faced, lack of proper explanation in terms of a novice’s language on the IRS site.

When I read it for first time, it was in Greek and Latin!

Here’s is my attempt to make Traditional IRAs simpler for you. Now please concentrate on the following sentences.

Definition: The individual retirement account is a personal, tax-deferred account for people who are employed, and their spouses.

You can set up an IRA at almost any bank, brokerage, insurance company, or mutual fund. There are a wide variety of investment options to choose from, and your earnings are untaxed until they are paid out of the account.

What Is IRA? Beyond definition

IRA stands for Individual Retirement Account. Consider it as your regular savings account. With a major difference that  it is mainly intended for your retirement. IRA is American equivalent of Canada’s RRSP, India’s Provident fund. In the UK, the equivalent is a  SIPP pension.

It is applicable to only those who are already working, the amount you invest in IRA may be tax deductible or tax free. If you contribute $2,000 a year in IRA, you get $2,000 deducted from your annual taxable income.

Where it differs from a saving account?

You can invest this amount in any form of investment, and you can’t take money out of it.

Now, to make it a little more broad, IRA is an account where you can hold different types of investments. Don’t get confused with a mutual fund account, or a share trading account

Your IRA account can hold any and every type of investment in it. This is your retirement portfolio. You decide where to keep your money within this portfolio.

You can invest part in CDs, part in mutual funds, part in stocks or even bond and money market funds.

The most interesting aspect is, you can even invest in real estate from your IRA fund.

A few things that you should keep in mind now, before going in to further details about IRA

Basic pillars of IRA

1. Simple to open. You can open IRA account from your home using IRA provider’s website or you can physically visit a provider’s branch to open an account

2. There is a limit to contribution. As per current policy, you can’t invest more than $5,000 per year till you’re 50 years old.

3. Tax is deferred, not waived. Since you don’t have to pay taxes on the IRA contribution, and since the fund is saved for retirement, you need to pay back the taxes you saved when you withdraw from IRA before you are at retirement age (59.5 to be precise). Fair enough, right?

4. There’s a penalty for early withdrawal. To discourage you from eating in to your IRA account before you are old, there is a 10% early withdrawal penalty.

5. Few withdrawal are exempt from penalty. The govt, is not heart less either, after all they are public servants. So, if you withdraw from IRA before attaining retirement age for the purpose of your home buying or student education, the withdrawal is penalty free. Although you still have to pay regular income tax on the money you withdraw from IRA.

6. IRA has to be opened through a custodian. IRA providers are actually licensed institutions that acts as a custodian of your money. They ensure you don’t withdraw money from IRA account without paying taxes and penalty. They also provide you various options to invest your money. In turn they charge you fees.

Now let’s take an example

Let’s assume you joined work force when you were 25. You contributed $5,000 per year towards traditional IRA ever since. When you are of age 30 you have saved $25,000 in contribution, and earned $8,000 through investment gains (rough estimate). You now have $33,000 in your IRA account.

You have saved on almost $1,250 per year on taxes. Making total tax save in last 5 years as $6,250.

Case 1 – You want to withdraw $15,000 to buy car. Since car buying is a need that is not penalty free, you have to pay 10% penalty when you file your tax return. To withdraw that much amount from IRA, you need to pay $3,750 towards regular income tax (assuming you are in 25% tax bracket) and $1,500 towards penalty, making the total payment to the government $5,250

You’ll now have $18,000 – $5,250 = $12,750 in your IRA account.

Case 2 – you want to withdraw $15,000 towards higher education. No penalty applies this time and you end up with $18,000 – $3,750 = $14,250 in your IRA account.

What you can invest in with your IRA money?

Pretty much everything. Its your money. You can make it grow or shrink with whatever way you can.One thing you are severely limited to, is your IRA broker’s limitation. If they allow you to invest in high-end collectibles, you can do that.

Before coming to the question of selecting your broker, let us look at IRA investment options in more details.

IRA investment options

1. CD – This seems to be the best risk free investment option. For me, I have still 25 years to reach theat age of 59.5 I can take maximum benefit of long-term CD rates. As per the date this article is written, the best 5 years CD rate is 2.35%. I can get that rate easily.

If you are near your retirement and only have few years left, you may not want to go for 5 year CDs, then the short-term CD rate is around 1%.

2. Stocks/stock funds – You can investment in any individual stock of fund you wish. generally accepted long-term stock market return is 7%. So, if I buy a stock index fund I can wish for that return. 7% compared to 2.35% is huge. SInce stocks can go down in value, I would rather not put entire IRA money in to stocks.

The advantage of regular stock investing vs. normal stock investing is, with IRA money you can keep a well performing stock forever, till you retire. Where as in regular stock investing, you need to sell your shares when you need the money. More freedom can some times works against you.

3. Money market fund – If you are reading this article, probably you have money in your checking account and you are contemplating on opening an IRA account, you just need a few more information, right?

The money you have in your checking account, is not giving you any return, in fact the value is depreciating according to inflation rate.

Your money in IRA account, even if not invested anywhere, grows.

This is because the brokers invest the money in money market funds. Even if the amount is small, still you earn. You have the flexibility to choose which MM fund should get your money.

4. Bonds – You can buy individual company papers, bonds, bond funds, municipal bons, etc. with your IRA money.

5. Real Estate – IRS laws prohibits IRA money to be used for buying properties for self use.

To buy a home you need to withdraw money from IRA and pay penalty. But, if you are buying real estate for investment purpose, you are allowed to do so.

Purchasing, home, apartments, land, etc. is allowed with IRA money for investment purpose.

6. Other options – There are many other investment alternatives available, but in order to do that You need to be consulting with financial planners.

How Can you open IRA account

Have you opened a checking account? if yes, then you know how to open an IRA account.

It is as simple as filling out a paper or electronic form with your personal data and submitting the form to your IRA custodian or broker.

You can open as many IRA accounts with different brokers as you wish. I don’t do it and won’t even suggest you doing that. because, money in a single account makes it so much more easier to manage than having it scattered across various accounts.

Saying that, let’s see how can you choose where to open your account.

1. Go with the broker that provides maximum investment options.
2. Go with the broker that charges less fees. The brokers allow you to open IRA account only because they earn fees in return.
3. Go with the broker that gives you every details regarding your investments and updates the value daily.
4. Go with the broker that provides online account management as well as provides branch network access.
5. Go with the broker that already has a large customer base, with size comes security and better practices.

My account is with TD Ameritrade. They satisfy all the above criteria. There are many others who does too. You can open an IRA just about anywhere; Banks, brokerage firms, discount brokers, mutual fund companies, etc.

What happens after I open IRA account

• I Check my account value growth every month. TD Ameritrade does provide a dashboard with details of my various investments. I compare the actual return with market return. I compare with other investment options. I try to re distribute investments every year.
• I try to avoid too many transactions, to avoid fees.
• If I am eyeing for a specific fund, and that has a minimum purchase price set, I wait for the IRA monthly contribution to add up and reach that minimum before I buy the target fund. Till then, the money earns a small interest through automatic money market investments.

Why should you open IRA Account?

There are two reasons.

1. To have sufficient retirement saving. This is major benefit of IRA. We have life priorities and limited income. Home, Car, education, vacations, marriages, child-birth, etc. eats in to our income. Saving $5000 a year in your IRA account for 30 years, at 5% would give you $349,000. Read how much do you need for retirement.

I considered 5% return because, I prefer to have investment mix, with CD, stocks and bond in my portfolio.

2. To save taxes. Your taxable earning is deducted by the amount of investment you make in IRA. With 25% tax bracket, I save $1,250 a year on taxes, as I max out IRA contribution.

There are other alternatives to IRA, Roth IRA, which will be discussed in a few days. For more information, you can read the IRS guide to IRAs.