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Individual Retirement Accounts (IRAs)

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The Importance of Timing Your IRA Contributions

Most people start thinking about funding their IRAs when they meet with their accountants in April. While funding an IRA at that time of year is better than never, you should know that the earlier you stash some money in your IRA, the better.

If you fund an IRA in January or February, the funds begin to work, tax deferred, with gains starting immediately and accumulating for the entire year. You get twelve, maybe fifteen months of deferral by funding your IRA in January, rather than waiting until it's time to file your tax return. If it's not financially feasible to fund your IRA all at once, you might consider contributing some money each month, beginning in January.

Roth IRAs

This variation on your basic IRA has been popular since it was introduced in 1998. The Roth IRA is different from the traditional one in several ways, and many financial experts agree that it is better than the traditional IRA for people with the right circumstances.

Show Me the Money

A Roth IRA is an IRA in which the funds placed into the account are nondeductible. If held more than five years, the original funds withdrawn are received tax free, but the earnings are subject to a penalty if withdrawn before age 59.5.

Show Me the Money

There's also an IRA called an educational IRA. As the name implies, it's set up especially to fund education expenses.

Dollars and Sense

If you still have a traditional IRA instead of a Roth, you might want to consider switching it. You can do this if your income (single) is under $110,000. You'll be taxed on the money you're converting, but advisors say that you're still better off to move it, especially if you're under 50 years old. If you don't understand the implications, it would be a good idea to check with a financial advisor.

For starters, your contribution to a Roth IRA is after-tax money, as opposed to the traditional IRA, in which your contribution is pre-tax money. Huh? Okay, when you contribute to a regular, deductible IRA, you put in $3,000 (or whatever) before you pay tax on that money. When you take your contributions and your earnings out at retirement, you have to pay taxes on that money. With a Roth IRA, your $3,000 contribution comes out of income you've already paid taxes on (that is, earnings). The funds contributed accumulate tax free, and if held for five years, you never pay tax on the money withdrawn. Yep, you heard it. If you follow the rules and hold the funds within the Roth for five years, you never have to pay tax on the account again. That means you get all the earnings on that $2,000, or $3,000 or $4,000 or $5,000 tax-free, which is a very appealing feature of the Roth. Contributions to a Roth IRA, however, are not tax deductible.

The new contribution limits for Roth IRAs are the same as for traditional IRAs (as stated above). So, by 2008 you could contribute $5,000 to a Roth IRA if your income is less than $110,000 (if you are single; $160,000 if you are married filing jointly).

You can get your Roth money without penalty any time after you reach 59.5 years of age, but you're not required to take it out when you reach 70.5 as you are with traditional IRAs. You can just let that money sit there if you want to, continuing to grow, tax-free. You can even leave the money and all the earnings there to pass on, tax-free, to your heirs.

There are income limits to Roths, though. If your income is more than $110,000 and you're single, you can't get a Roth IRA. If you and your spouse have a combined income of more than $160,000, then you're not eligible for a Roth IRA.

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Excerpted from The Complete Idiot's Guide to Personal Finance in your 20s and 30s © 2005 by Susan Shelly and Sarah Young Fisher. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

To order this book visit the Idiot's Guide web site or call 1-800-253-6476.


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