Tax Shelters and Traditional IRAs
Tax Shelters for Retirement Income
Investing for retirement income is so important that the government has put together programs that encourage people to save for their retirement. Income contributed into these government sanctioned retirement savings program investments is tax-sheltered. Contributions are made to qualified retirement plans on a pre-tax basis. Monies deposited into a retirement plan are subtracted from the amount of income upon which you are required to pay taxes. This means that you pay less in taxes even though your income has not changed.
Another boon to investors of qualified plans is that dividends and capital gains earned on invested monies are not taxed until you begin making withdrawals (with a classic 401(K)). This means that you don't have to pay taxes on invested money during the period that it is invested and compounding. Because you don't have to pay taxes on the interest you earn on your tax-sheltered investments, that interest is added to the balance of what you have invested rather than going into the government treasury. The extra money remains available to grow in a compounded manner. Over many years of steady investment, and the magic of compounding interest, tax-sheltered retirement investments will grow faster and larger than will taxed investments. These are wonderful benefits to take advantage of. It will be in most people's interest to contribute as much to their qualified retirement accounts as they can manage so as to take the fullest advantage of this benefit.
There are several types of tax-sheltered retirement investment programs. Each type is available to different classes of people (based on their type of employment, primarily), and each type offers different benefits and problems.
Traditional (or "Classic") IRA
The abbreviation IRA stands for Individual Retirement Account. The classic or traditional was created in 1974 to allow employees without pensions to more easily save money for their retirements.
The Traditional IRA is a "qualified" account, which means that monies in an IRA receive special tax treatment. In a Traditional IRA, you contribute money on a tax-deferred basis, meaning that you don't have to pay taxes on that money for the years that it will be invested. Taxes are not due on this money until you withdraw from the account during your retirement. Money invested in a Traditional IRA grows tax-free for years until it is time to draw on the IRA account during retirement. Then the money is taxed as it is withdrawn.
Various different Traditional IRA products offer many different sorts of investment opportunities. IRA money can be invested in mutual funds, stocks, bonds, CDs, and annuities, for example.
As is the case with other "qualified" and tax-sheltered retirement accounts, there are certain conditions that govern how the Traditional IRA account may be used.
The first rule is that once money goes into the account, there is a penalty of 10% that applies most of the time (there are financial hardship exceptions) if you try to withdraw the money before age 59 ½. This penalty is there to encourage people to leave their invested retirement money alone. You cannot take loans against an IRA, either.
The second rule is that you cannot leave money in the IRA after a certain age. You must begin taking withdrawals by age 70 ½.
There are rules to how much you can contribute to a Traditional IRA too. At the present time, contributions are limited to a certain amount for those 50 and under and those who are older than 50 can contribute an additional amount called the "catch up" contribution to help those who might have delayed savings for retirement to catch up.. These limits are expected to change every year with inflation, so check with this IRS page (http://www.irs.gov/Retirement-Plans/COLA-Increases-for-Dollar-Limitations-on-Benefits-and-Contributions) for the current limits.