IRA-Lets Understand Nuts and Bolts of this tax saving vehicle

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IRA stands for Individual Retirement Account and there are two types of IRA account.

Traditional IRA-Part I

When we near the retirement ages or listen to anyone showing tax saving techniques, we hear this word IRA, invariably. Let us understand IRA, starting from basic concept, stretching it to complex tax planning technique.

  • IRA stands for Individual Retirement Account. An IRA is a trust created in the United States for the exclusive benefit of you or your beneficiary. In normal conversation, when someone is referring to IRA, it is understood as Traditional IRA. Another variety of IRA is ROTH IRA, but in general conversation, people call it just ROTH.
  • Why should I contribute to IRA?

Usually, people perceive Retirement as an event which is way too distant in future. So the word IRA coupled with Retirement does not create much appeal to them. They neglect to reflect upon the biggest benefit that IRA provides-Tax deferred growth of your investments. Once the money is invested in IRA, it grows Tax Deferred and when you take the money out, only then you pay taxes on those investments.

Because we are talking about numbers, let’s understand it with example.

Say you invested $5500 in IRA in 2017, on Jan 2017.

You receive about 5% return on that amount till 2027. Assuming that you have not made any additional contribution to the IRA, you earned $275 as simple interest.

As these earnings are in Tax Deferred account, you will not receive 1099 for the earnings, will not include the amount of earnings in your tax return and will not pay any taxes on those earnings.

Assuming that you are in 20% tax bracket, you are deferring $55 in taxes.

If you leave this amount in IRA and wait till 2027, this amount will grow to $8958.92, compounding annually at the rate of 5%. This results in tax deferred earnings accumulating in your account of $3458.92. You did not pay any taxes on these earnings, resulting in tax savings of $691.78.

In other words, if you would have saved that same $5500 in your general checking account or brokerage account and earned the similar earnings, you would have paid at least $691.78 in taxes.

 

This is not the only reason for investing in IRA. We will cover another benefit in next segment.

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