Retirement planning for Sacramento residents is important and, even if you haven’t started, it is never too late. A common misconception among residents is that you can be dependent on your Social Security benefits alone. Instead of risking your retirement on something unpredictable, it is better to be proactive and create a proper retirement plan as soon as possible. If you do that, you should be able to relax and enjoy your retirement the way you should. The easiest way to get started is by establishing an Individual Retirement Account or IRA. An IRA can help you start saving and investing in your future.
The definition of an IRA and how it works
An IRA is essentially an investment account that offers tax advantages as well as a reliable way to save money for your retirement. With an IRA, you are not required to pay taxes on the investment earnings from the account. Instead, the investment earnings can be reinvested and compounded so your account can grow as much as possible. Once you reach retirement age and begin to make withdrawals from your IRA, the tax consequences depend on three factors: the type of IRA you have, your present income and the amount of your withdrawals.
The different types of IRAs available
There are actually four different types of IRAs which have their own advantages. Traditional IRAs and Roth IRAs are opened by individuals, as opposed to Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are made available through employers. Nevertheless, each type of IRA is considered “fully vested,” meaning that contributions and earnings belong to the owner of the account, even contributions made by employers.
There are limitations on contributions to IRAs
The IRS has imposed certain limitations on the total amount of contributions that can be made to an IRA account each year. These limitations often change so it is wise to consult with your retirement planning attorney to confirm the current limitations being imposed. However, these limitations did not change from 2016 to 2017 for most types of IRAs.
The maximum contribution for both Traditional and Roth IRAs is $5,500, for individuals under the age of 50. For those over age 50, the limit is $6,500. The maximum contribution for a SEP IRA increased to $54,000. The limit for a SIMPLE IRA is $12,500 if you are under age 50 and $15,500 if you are older.
Deductible IRA Income Limit
There are some income limits imposed when it comes to taking a full tax deduction for your contribution. Those income limits for traditional IRAs have increased for 2017 to $62,000 for individuals and for those who are married filing jointly, to $99,000.
How Traditional and Roth IRAs are different
Traditional IRAs are different from Roth IRAs because they are funded with “pre-tax” dollars. That means you do not pay any taxes on your contributions or the interest those contributions earn until you start taking withdrawals during your retirement. At that point, each withdrawal you make is taxed as ordinary income.
However, a Roth IRA is funded with “after-tax” dollars. Roth IRAs do not provide any tax benefits relating to contributions. But, the earnings and withdrawals from Roth IRAs are generally tax-free. A major benefit of Roth IRAs is that, not only are your earnings allowed to increase tax-free but when you retire and begin receiving withdrawals, you do not pay income taxes. Essentially, you can avoid taxes when you contribute to a traditional IRA, but you avoid taxes with a Roth IRA when you withdraw money at retirement.
Understanding early withdrawal penalties
With all IRAs, the government charges a penalty for early distributions or withdrawals. With traditional IRAs, you will pay an additional 10% penalty if you take any distributions before you reach the age of 59½. The penalty is in addition to the income taxes that are imposed. One benefit of a Roth IRA is that you can withdraw your original contributions at any time, without penalty because you essentially paid income tax on those funds already. However, early withdrawals of your earnings are subject to the 10% penalty, in addition to income tax. The Roth IRA has an additional requirement. Along with the age requirement of 59½, a Roth IRA must be in existence for at least five years before you can begin to withdraw earnings, without penalty.
Care is Needed in Designating Beneficiaries
It is important to coordinate your IRA accounts with your estate plan. While many people will directly designate their spouse and/or their children as direct beneficiaries of their IRAs in the event there is still a balance in the account at the death of the original IRA owner, in many cases, those choices are unwise. Situations like blended families, disabled children or grandchildren, minors, financial immature beneficiaries, among many others, require great care in designating the beneficiary for an IRA. The best way to learn what is right for your situation is to consult with an experienced and qualified estate planning attorney.
Download our FREE estate planning checklist today! If you have questions regarding an IRA, or any other retirement planning needs, contact the Northern California Center for Estate Planning and Elder Law for a consultation, either online or by calling us at (916) 437-3500.