This content is provided courtesy of USAA.
IRAs, employer-provided retirement plans, mutual funds, CDs and annuities: These are the basic investing tools that could eventually allow many of us to put the 9-to-5 routine in the rearview mirror. Here's what they are and how they might help with your financial goals.
1. IRAs for Individuals
Many people think of an IRA as an investment, but that's a misconception. "Think of an IRA as more of a container to hold investments, rather than an investment itself — a container that provides tax benefits," says Scott Halliwell, a CERTIFIED FINANCIAL PLANNER™ practitioner with USAA. An IRA can be used to make investments in stocks, bonds, mutual funds, certificates of deposit and other securities. There are several types of IRA-based plans, including traditional IRAs and Roth IRAs, each with different rules and benefits.
A traditional IRA allows you to save and grow your money tax-deferred until you withdraw funds. If your workplace offers a retirement plan, however, you may not be eligible for all of the benefits of an IRA or they may be reduced. To encourage you to leave money in your IRA until you retire, withdrawals before age 59½ generally get dinged with a 10 percent penalty by the Internal Revenue Service — that's in addition to the taxes you will have to pay. Here are some other IRS rules for IRAs:
- In 2012, contributions are capped at 100 percent of taxable compensation, not to exceed $5,000 a year. That cap is $6,000 if you're 50 or older. If your taxable compensation is less than these amounts, you may still be able to contribute if you file jointly and your spouse earned enough to cover both of your contributions.
- You can withdraw money before age 59½ without a penalty for certain expenses, such as a first-time home purchase, education, a disability, or medical premiums and expenses (there are some limits).
- You can participate in a traditional IRA regardless of how much income you earn. However, if you earn above a certain amount, your tax deductions for contributions may be limited if you are also covered by an employer plan.
- You must take minimum distributions each year from a traditional IRA once you're 70½.
A Roth IRA can be a more flexible way to save and invest for retirement, depending on your income. Though generally discouraged because it can damage your retirement savings, Roth IRA contributions can be withdrawn at any time without penalty. This exit feature may be key to encouraging retirement savings among those who otherwise might be hesitant to make the long-term commitment.
Roth IRAs have the same contribution limits as traditional IRAs, but only investors who have a modified adjusted gross income less than $110,000 (if single) and $173,000 in 2012 (if married and filing jointly) can make a full Roth contribution. Single investors making at least $110,000 but less than $125,000 and married investors making at least $173,000 but less than $183,000 in 2012 are only allowed to make a partial contribution.
A Roth IRA doesn't provide the immediate tax breaks of a traditional IRA, but it does offer many of the same and additional benefits:
- You can contribute to a Roth IRA as long as you have earned income, regardless of your age, and you don't have to take withdrawals after you turn 70½.
- Your contributions and earnings grow tax-free. You can withdraw your contributions — but not what you've earned on them — at any time for any reason without paying taxes on them.
- In 2012, you can save up to $5,000 a year, or $6,000 if you're 50 or older.
- If the account is at least five years old, you can make early penalty-free withdrawals of your earnings under certain circumstances. These include some first-time homebuyer expenses and medical expenses (limits apply for both), and if you're disabled.
2. Employer Plans: 401(k)s, 403(b)s, Thrift Savings Plans
These retirement accounts are similar to an IRA in many aspects, but they are sponsored by your employer rather than opened by you. Major similarities include tax deferment for savings, a limit on yearly contributions and penalties for taking out money early. Additionally:
- Your investment choices are generally limited to those offered by your plan, but they typically include a variety of alternatives and risk levels.
- If you leave your job, you can take the money you save in your account with you by rolling it into an IRA or into your new company's plan, if the plan allows.
- Some employers will match a percentage of your contributions to the account.
- Though generally not recommended, you can borrow from some plans and repay the amount within five years without getting penalized for early withdrawal. It is important to pay back the funds immediately when you leave the company. If not, the unpaid loan will be considered an early distribution and will result in taxes and possible penalties by the IRS.
- Contribution limits for these plans are higher than for IRAs. In 2012, you generally can save up to $17,000 a year, or $22,500 if you're 50 or older.
- Many plans now offer a Roth alternative as well.
3. Mutual Funds
A mutual fund buys investments with money it gets from selling shares in the fund. The fund's professional managers research and monitor the markets in which their fund invests and decide when to make purchases and sales. Because the manager is doing the heavy lifting, mutual funds charge fees. Additionally:
- A mutual fund is often made up of dozens of investments, so its success isn't dependent on one or two holdings.
- You can typically sell your shares in a mutual fund at any time.
- The variety of mutual funds is virtually endless. Funds can have a focus on a particular industry, such as health care or oil and gas; invest in companies based in a particular region, such as Asia; have a special objective, such as social or environmental responsibility; or concentrate on a type of security, such as bonds.
- Certain mutual funds, such as target funds, even change investments automatically to reduce risk exposure as you get closer to your projected retirement date.
- Mutual fund investments are not insured and offer a variable return.
4. Certificates of Deposit
A bank certificate of deposit is a federally insured deposit issued by banks, savings and loans, and investment companies that entitles you to a specified interest rate. CDs have a maturity date generally ranging from one month to seven years. You can use money in an IRA to purchase a CD just as you would a mutual fund or stock. Additionally:
- CDs generally start as low as $1,000 for three months or more.
- The interest rate is generally locked in for the maturity term you choose.
- The Federal Deposit Insurance Corp. insures CDs up to $250,000.
- If you withdraw money from your CD before it matures, you usually have to pay a penalty.
An annuity is a contract issued by a life insurance company designed to meet retirement or other long-term goals. It can work for you whether you are currently saving for retirement or already retired by guaranteeing a portion of your assets.
Annuities can be divided into two broad categories: deferred annuities and immediate annuities. Deferred annuities let your money grow tax-deferred over time with a choice to provide a steady stream of income during your retirement years. Immediate annuities can let you exchange a lump sum of money for a monthly income that is guaranteed to continue for life. The fixed annuity guarantee against principal loss depends on the claims-paying ability of the insurance company. Additionally:
- Some annuities offer market-based investment choices while others only offer fixed rates.
- Annuities generally charge fees for early withdrawals, called surrender charges.
- Some annuities offer a fairly complex array of benefits and can be expensive to own. Care must be taken to clearly understand what one is getting and what it costs. Some costs associated with annuities include surrender fees, early withdrawal penalties and mortality risk expenses.
- Annuities do not provide any tax-deferral advantage over other types of investments within a qualified plan.