Updated: May 3, 2013 12:14PM
Originally published: April 21, 2002
Forgive me for repeating myself, but I hate to see you pass up a chance to pick up some tax-free money--and you only have until Monday to open your Individual Retirement Account.
I just don’t want you to miss out on the very realistic probability of turning $2,000 into nearly $50,000--tax-free--by the time you retire in 31 years.
So here’s your last-chance instruction kit for opening an IRA for 2001. And it’s also a road map for opening another IRA for 2002.
What is an IRA?
An Individual Retirement Account is your chance to set aside money to grow, either tax-free or tax-deferred, for your future.
A traditional IRA allows you to make a contribution of up to $2,000 of earned income and deduct that contribution from your 2001 income taxes. As the money grows in your investment account over the years, you do not pay taxes on the gains or interest. Instead, you’ll pay ordinary income taxes when you take the money out after you retire.
What is a Roth IRA?
A Roth IRA allows you to make a contribution of up to $2,000, but the money comes out of your pocket after you have paid taxes on it as income. However, when you withdraw the money after retirement, all of the gains you’ve built up over the years come out completely tax-free!
You can open a Roth IRA if you earned less than $95,000 in adjusted gross income on a single return, or $150,000 on a joint return last year (2001).
You can open a traditional IRA and deduct your contribution if you were not covered by a company retirement plan or if you were covered by a company plan, but had income below $33,000 on a single return or $53,000 on a joint return.
And you can open a traditional IRA, but not take the tax deduction, if you were covered by a company plan, still want to contribute, and earned too much to qualify for a Roth IRA.
Important note: Spouses who do not hold a job can also open an IRA, even though they had no outside income.
That spousal IRA contribution can be deducted on a joint return if the working spouse (even if covered by a company plan) had income of under $150,000. Or the non-working spouse can open a Roth IRA, again assuming joint income under $150,000.
Special note: Although you are allowed to contribute up to $2,000, you don’t have to put in the full amount if you can’t afford it.
Which kind is better?
I’d suggest you open a Roth IRA, if you can manage to put money in without the tax deduction.
Over the long run, the tax-free withdrawals at retirement (and I’m assuming the government keeps its promise to the millions of people who are building money in Roth IRAs) will far outweigh the current tax deduction.
When can I withdraw money? The basic rule with a traditional IRA is that you must leave the money growing inside your IRA until you reach age 591/2. If you take money out before that, you’ll pay ordinary income taxes on any gains, plus a 10 percent federal tax penalty.
A Roth IRA has slightly less restrictive rules. You still have to leave the money in the account until age 591/2--and have had the account for at least five years--to qualify for tax-free withdrawals of gains.
And I hate to tell you this (because I want you to leave the money inside your Roth until retirement) but if you really need to tap the cash, you can take out your contributions without penalty at any time.
Where should I open my IRA? This is the easiest part, but it’s also the moment when good intentions go astray just because you now have to take action. If you have 20 years or more to retirement, my best advice is to invest your IRA in a stock market mutual fund. That doesn’t have to be complicatedor expensive.
And you don’t have to be a genius at picking mutual funds. The easiest thing is to buy an “index” fund--a portfolio of stocks designed to mirror a popular stock index such as the Standard & Poor’s 500.
Using an effective index fund means your returns will be in line with the stock market. But you don’t have to use a mutual fund. Just walk into your nearest local bank and open an IRA certificate of deposit account, or you can open an account at any brokerage firm. Here’s how I calculated that gain at the beginning of this column--how $2000 grows to $50,000.
If you invest $2,000 in a stock market index fund and if the stock market equals its average returns of the last 30 years--about 10.6 percent per year--then your $2,000 would grow to $45,540 in 31 years.
There are no guarantees in the stock market of course, but it’s certainly a better bet than a lottery ticket or a dream.
And that’s the Savage Truth.
Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail to firstname.lastname@example.org. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast.