Let’s say you’ve got more income than you have expenses.
Wait, keep reading.
Let’s just say.
If you’re saving money, the odds are pretty great that you’re not using an IRA. An Investment Company Institute survey published in January indicated that the highest incidence of IRA use was with heads of household age 55 to 64, at a rate of 37 percent.
Younger families and individuals used IRAs even less frequently — heads of household under 35 participated at a rate of 28 percent. Part of that is because, according to ICI, half of all IRAs were created as destinations for rollovers from 401(k)s. Part would be people who simply don’t have enough money to save. And another part would be people who don’t really know what an IRA is.
“People that do know about an IRA — or a 401(k) — they know about it basically through an employer,” says Carlos Colón, a personal finance coach at mPowered, a Lakewood nonprofit organizition that offers financial counseling, often to people working to get out of debt. “How it functions, the allocation, the portfolio management and so forth, they’re not as aware of,” Colón says.
And yet, the IRA (individual retirement arrangement, or account) is among the most accessible retirement savings vehicles, likely better in some ways than your 401(k). You could stop reading this story — again, please don’t — to start setting one up, and with minimal time investment over the course of a couple of days, you could start saving for retirement automatically every month, kicked off with an investment just in time to count for 2014.
What an IRA can do
You might consider an IRA for two main reasons (outside of having maxed out your 401(k) at $17,500 last year, an event with which we’ll not concern ourselves).
One, you have options.
“You can invest in almost anything,” says Victor A. Amaya, a Certified Public Accountant with ClearPath Accountants in Littleton. While the average 401(k) plan offers 25 different investment options — which aren’t always great, or can have high fees — there’s no end to the kinds of things you can invest your IRA savings in.
“It’s not different from a brokerage account,” Amaya says. In other words, apart from the tax incentives meant to encourage you to save for retirement, it’s basically the same as investing in stocks, mutual funds, whatever.
Of course, nothing is a guarantee, and that’s scary. No amount of financial literacy can protect you from other people’s bad behavior, nor from economic crises.
But there are options that don’t take a ton of research, and they get the stamp of approval from financial pros. Amaya isn’t alone in recommending target-date funds, which estimate an investor’s priorities and risk profile by the date when they’d like to retire — so if you were born in 1970 and plan on working until you’re 70, you might buy into a fund that has the year 2040 as its target date.
Says Amaya, “Usually for people that are not too savvy — they don’t quite understand how the market works and are very risk-averse — the target funds are very good, because somebody already put a vehicle together.”
The second reason you might consider an IRA is that, in the case of the Roth IRA, it’s giving you tax diversity when combined with a 401(k). Where your 401(k) is tax-deferred — meaning you don’t pay taxes on contributions now and instead pay them later, earning money on a larger principal investment — the Roth IRA is tax-exempt. You’ll pay taxes on the money in the year you earned it, but once you invest it in a Roth IRA, you won’t pay taxes on the money you earn on investments.
There are many more rules and stipulations, and it’s worth talking to a professional to make sure you’re saving in a way that matches your priorities, but that’s it in a nutshell — if you’ve got both a Roth IRA and a 401(k), you’re protecting yourself against taxes either going way up or way down.
What an IRA can’t do
The conventional wisdom is that you should have an emergency fund and you should be saving for retirement, and then you should take care of other needs.
The emergency fund should be able to cover anywhere from three to 12 months of expenses if you were to lose your job — it varies depending on who you ask — and it should be kept accessible.
And those things should be discrete. An IRA is not a good place for an emergency fund. Says Amaya, “When you take money out of your traditional IRA, you’re looking at a 10 percent penalty on your withdrawal, and then you also pay your taxes, so even at a lower tax bracket, you’re paying 25 percent if you take out of your retirement account.”
Of course, people still do it. And more than you might think.
“A lot of it is, that’s really the only savings they have,” he says.
Another part of the problem, according to Boston College’s Center for Retirement Research, is that it’s simply easier to take money out of an IRA than it is to take money out of a 401(k). There are fewer restrictions, resulting in retirement savings “leakages.”
From a February CRR report: “Over the past few decades, the potential for leakages has greatly increased due to two developments: 1) the shift from defined benefit plans to 401(k) plans; and 2) the movement of retirement assets from 401(k)s to IRAs.”
With great shifts in infrastructure like that, it shouldn’t be a surprise that people don’t know how these savings vehicles work.
“We’re not taught to talk about money or to educate ourselves,” says Colón. “There’s no formal education outside of certain providers. And the financial sector, which (often) provides the education, is biased because those people are selling products.”
Dave Burdick: 303-954-1957, dburdick@denverpost.com
Learn more about retirement savings
While you may not be getting the financial education you need at work or in school, there are resources online you can use to try to fill the gap.
irs.gov — Search “IRA” and you’ll find information on the different types of IRAs and a surprisingly approachable “Getting Started” guide.
tinyurl.com/motleychoice — The Motley Fool site has a simplified explanation of weighing the benefits of a 401(k) against those of an IRA.— Dave Burdick
