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IRA – Individual Retirement Accounts – How Do They Really Work and Why Should You Have One?
Wage earners in the United States have part of their income withheld to pay into the Governments Social Security program. It was started in 1935 by then president Franklin D. Roosevelt. Its function is just as the name describes, that you will have security from this program in our society. The program is built on the premise that when you become too old to earn a living wage, you have a right to draw from this mass fund for income to live. It also provides for funding if you become disabled or for your survivors.
For a variety of reasons we as a society are outspending that fund. It’s long been known you can’t rely only on it, and should be building a supply of your own.
The wages you earn now are taxed depending on the bracket you’re in. The higher the bracket, the higher the tax. By taking part of your income now and depositing it in an IRA, known as making a contribution, you are then allowed to not be taxed on that money when you calculate that years earned wage on your income tax returns.
Now there are two kinds of IRA’s, Traditional and Roth. We’ll talk about Traditional IRA’s in this article.
You may start drawing from your IRA, or taking distributions, when you reach age 59+1/2 without any penalties from the government. But if you take a distribution prior to that there will be a penalty imposed by the government. Additionally, you must take RMD’s – Required Minimum Distributions from your IRA once you reach the age 70+1/2. The government has charts that mandate what percentage of your IRA you must take each year going forward.
You are taxed on the income the year you take your distribution. The hope is when you were earning the money in your younger years, your contributions were a help to you as a tax deduction. Now that you’re older and making less income you should be in a lower tax bracket, so the money you take as distributions won’t throw you into such a high tax bracket that you’re paying a lot of income tax on it.
IRA money can be deposited in a wide variety of accounts or ‘vehicles’. Make sure you get solid advice from a financial counselor and are well educated on the subject before putting your money anywhere. Some products are tied to the stock market and will not guarantee your money will not lose value. These products also have the potential to grow larger faster, but it is a risk. Other products guarantee a much lower rate of return, but you can be sure your deposited money will be there and then some. Perhaps you might want to take some risk with some of your money when you are younger, but as you age and come closer to the time of retirement move your funds to something less risky.
On the safe side, FDIC insured products at banks include both liquid and non-liquid types of accounts. The FDIC - Federal Deposit Insured Corporation – is an independent agency that was started by Congress. This is basically a giant insurance fund. Banks pay premiums to the FDIC to be a part of the program. If a bank goes under or losses money the FDIC guarantees it will pay the consumers their funds back, based on their guidelines. Currently, FDIC insurance is $250,000.00 at each bank you have money deposited. IRA funds carry an additional, separate insurance coverage of $250,000.00.
Products within a bank could include IRA Savings account, which generally have a very low interest rate but the money is liquid, meaning you can withdraw from it without a bank penalty. CD’s, or Certificates of Deposit, are an agreement between you and the bank for a specific length of time to leave the money untouched in the account. They generally range from 3 months to 5 years, but there are some banks that carry shorter and longer terms. The shorter the term, the lower the interest rate. Then longer the term, the higher the interest rate. So it’s best to take the longest term you are comfortable with and earn the most interest on your money. When you reach 70+1/2, most banks will allow you to take your RMD bank penalty free, if you’re in the middle of your CD term, but if you are not of the age that a distribution is required, they will charge you a penalty to take money out of the CD during its term. Keep in mind these bank penalties are separate from the government guidelines and penalties from taking distributions. Bank rules and guidelines vary at each bank.
It works best if you can estimate ahead of time if you know how you’ll want to use your money. If you have enough money to live on and can lock down your savings, you’ll earn more in interest that way. If you’re unemployed or facing a life tragedy of illness and are needing to use some of your retirement funds to help with expenses now, keeping it liquid to avoid bank penalties is the better thing to do.
You can open IRA accounts at multiple banks and investment firms. Once you start taking Required Minimum Distributions you can no longer make contributions to your IRA accounts. Your RMD amount is based on a combined total of all of the money you have in accounts you may have at various institutions. Once your required distribution amount is determined, you can take it all from any one of those accounts, or you can take some from one place and some from another. The best thing to do is take the distribution from the account that is currently earning the least amount of interest.