IRAs Are One Ingredient in a Balanced Retirement Savings Plan

In 2009 the venerable Individual Retirement Account (IRA) turned 35 years old. IRAs were created in 1974 by the Employee Retirement Income Security Act (better known as ERISA) to give individuals who weren't covered by employer plans a tax - advantaged way to save for retirement. They were intended to complement the employer-sponsored retirement system that was in place at that time.

Over the past 35 years, millions of Americans have used IRAs to save money for their retirement. According to the Investment Company Institute (ICI), an estimated 47.3 million U.S. households, or 40 percent, own IRAs.¹ IRA assets totaled $3.4 trillion at the end of the first quarter of 2009, which represents 25 percent of the $13.4 trillion in total U.S. retirement assets at that time.

While other retirement savings vehicles have come along since IRAs -- most notably, 401(k) plans -- IRAs remain the bedrock retirement savings tool for millions of Americans. "IRAs generally offer a lower expense structure than 401(k)s, which allows investors to keep more of what they earn," says Todd Tresidder, founder of FinancialMentor.com and a true believer in the power of IRAs. "They may also offer greater investment flexibility."

The Options
There are two main types of IRAs: Traditional and Roth.

Traditional IRA: The original IRA, now referred to as a Traditional IRA, is the most common: 37.5 million U.S. households own Traditional IRAs.¹ It offers tax-deferred growth and an immediate tax break in the form of a deduction equal to the amount of the annual contribution for individuals who qualify.

However, eligibility for this deduction phases out above certain adjusted gross income limits for individuals who participate in an employer-sponsored retirement plan (see "Head to Head" chart to the right). Taxes must be paid at ordinary income tax rates when distributions begin during retirement.

Roth IRA: This type of IRA is named after Senator William Roth, who introduced the legislation that created Roth IRAs in 1997. A total of 18.6 million U.S. households own Roth IRAs.¹

Roth IRAs differ from Traditional IRAs in two key respects. First, there is no tax deduction given for annual contributions. But this is offset for many individuals by the fact that contributions grow tax-free, instead of tax-deferred, which can make a big difference over the life of the account.

Another characteristic of Roth IRAs is that contributions (but not earnings) can be withdrawn tax-free and without penalty at any age. By contrast, an individual who withdraws from a Traditional IRA before age 59½ is usually subject to a 10 percent early distribution penalty. Therefore, many people use Roth IRAs as both college and retirement savings tools. Keep in mind that not everyone is eligible to contribute to a Roth IRA (see "Head to Head" chart above).

In 2009, individuals under age 50 who are eligible may contribute up to $5,000 to a Traditional and/or Roth IRA. This is the limit for combined contributions to both accounts. However, people age 50 or over can make an extra $1,000 "catch-up" contribution this year, for a total contribution of $6,000. These "catch-up" contributions were instituted to help those who may have had a late start toward reaching their retirement savings goals.

In addition to Traditional and Roth IRAs, special IRAs are available to enable small businesses to offer retirement plans to their employees. Congress created Simplified Employee Pension (or SEP) IRAs for small businesses and self-employed individuals in 1978 and SIMPLE IRAs in 1996 for companies with 100 or fewer employees. In 2009, individuals under age 50 may contribute up to $11,500 to SIMPLE IRAs (or $14,000 for individuals age 50 or over) or $49,000 to SEP IRAs. Assets in SEPs and SIMPLE IRAs totaled an estimated $224 billion at the end of 2008, according to the ICI.

Supplement Your 401(k)
Many people participate in 401(k) plans offered by their employers, an option that offers tax advantages and, often, an employer match as well. But long-term retirement savers and investors may find the flexibility that IRAs provide just as attractive.

"Depending on an individual's age and circumstances, it's usually smart to maximize all the tax-advantaged retirement savings vehicles that are available"says Tresidder. "To the extent that they qualify for both plans, most people would be wise to take advantage of the opportunity."

A key reason IRAs were first established was to give an individual changing jobs or retiring a way to preserve his or her employer-sponsored retirement plan assets by transferring, or rolling over, the balance into an IRA. Unfortunately, one of the biggest mistakes many 401(k) participants make is leaving their money behind when they change jobs.

Even worse, says Tresidder, is liquidating the funds and spending the money. "Often these people are between jobs and need the cash, which makes it easy for them to rationalize spending the balance of the account. By rolling it over into an IRA, they gain more investment control. And they can consolidate multiple 401(k)s into one place, simplifying administration and record keeping and benefitting from more investment flexibility and choices."

Checking In
Contributing regularly to an IRA via an automatic savings program can be a great way to invest and accumulate a retirement nest egg. Just as valuable, however, is reviewing your IRA from time to time -- particularly after events like marriage, the birth of a child, divorce or the death of a loved one. Because these changes may impact the status of a beneficiary, it's vital to revise designations accordingly. Doing so will help ensure your savings go where you intend.