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Two Cents: What the Heck Is an IRA?

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      What if I told you I knew a way to dodge taxes on a chunk of your paycheck? Or how about an investment opportunity that will never pay a penny of taxes on the growth, no matter how big it gets? Sound too good to be true?

      (host 2) No, we're not talking about some offshore account in the Cayman Islands. This is the amazing tax shelter of the IRA, a government-created program designed to incentivize you to save more for your future self.

      (Describer) In an animation, a piggy bank walks on top of dollar bills. A woman and man each appear on a penny. Above them, title: Two Cents.

      [bright music]

      (host 1) In 1974, Congress wanted a way to incentivize the country to start saving for their own retirement and rely less on government programs or company pensions. Their result was the creation of the first IRA.

      (host 2) The "I" stands for individual, meaning you don't get to co-own an IRA with someone else, and it's not dependent on a company offering it to you like a 401(k). The "R" stands for retirement, meaning you promise not to withdraw the money until you reach a certain age. And the "A" can either mean account or arrangement, according to the IRS. Contrary to popular belief, an IRA isn't an investment itself with a set interest rate or statistics. It's a holding cell for your investment of choice.

      (host 1) An individual retirement account can be set up at nearly any bank or investment company and can hold investments like mutual funds, stocks, or ETFs. But an IRA doesn't have to be an account. Individual retirement arrangements allow you to apply the same tax benefits to an investment like a piece of land or a small business. Some folks have even used this arrangement to tax shelter dairy cows, a car wash, and a habanero pepper farm. As long as you play by the rules, you can get pretty creative about what you choose to invest in. IRAs can be broken down to two primary styles: traditional and Roth. The traditional IRA is the OG IRA. When you're going traditional, you're allowed to save up to $6,000 a year, or $7,000 if you're over age 50, and as long as you meet the criteria, any money you save into a traditional IRA is tax-deductible. Translation: The more you save, the less taxes you'll owe this year.

      (host 1) And since you're paying less taxes, you have more money to potentially invest in your IRA. Essentially, it helps you boost up the amount you save every year, and as the years go by and your account grows, you don't have to report your growth on your taxes. But when retirement arrives and it's time to pull the money out, the amount you withdraw gets taxed as ordinary income.

      (host 2) If you're a freelancer or own a small business, you qualify for some special variations of the traditional IRA. The first is the SEP IRA. SEP stands for simplified employee pension and can be ideal for self-employed people. The SEP will allow you to raise your $6,000 funding limit to the lesser of $56,000 or 25% of your compensation. That's a huge potential tax deduction each year. But beware, if you have any employees, you'll probably have to fund their IRAs at the same rate as your own.

      (host 1) And if you work for or own a small business, the SIMPLE IRA is kind of like a traditional IRA blended with a 401(k). Available to companies with 100 employees or less, the $6,000 funding limit is raised to $13,000 and offers a savings match incentive to workers, usually a 3% matching contribution. So whether you own or work for the small business, the SEP and SIMPLE can help you level up a basic traditional IRA.

      (host 2) Then there's the Roth IRA, the cooler younger brother of the traditional IRA. Making its debut in the 1990s and named after Senator Bill Roth, the Roth IRA flips the tax benefit. Instead of getting a tax deduction on the income you put in now, the capital gains, interest, and growth can be withdrawn tax-free in your golden years with no limit. This is super attractive to younger investors. Since their investments can rack up so much compound growth over their lifetime, there's a potential boatload of taxes they can avoid.

      (host 1) Let's say you started maxing out your Roth IRA at $6,000 a year every year starting at age 25, and let's imagine that money gets invested in indexed funds that grow at an average rate of 8% per year. If you did just that until you reached 65, you would have around $1.67 million. Ah!

      (host 1) Under ordinary circumstances, whenever you profit from an investment, you need to pay taxes. But thanks to your arrangement with the government, your Roth IRA hooks you up big-time. In our simplified example, your gains account for $1.43 million of your $1.67 million, and assuming you owed a 15% capital gains tax on those gains, you'd normally be on the hook for over $214,000 in taxes. But thanks to the Roth, that number is zero.

      (host 1) A couple important things to keep in mind when investing through an IRA: First, you can't touch the money until age 59 1/2, or you'll get hit with taxes and a 10% early withdrawal penalty, though there are a few exceptions to this rule, like paying for college or buying a home, and contributions or deductions might be limited or eliminated if you and/or your spouse aren't working or have a 401(k) or other retirement plan through your job. And even nonworking spouses can save into their IRA if they choose. So which IRA is right for you? Luckily, you don't have to limit yourself to only one. Many people have multiple IRAs, as long as the total investment doesn't exceed your yearly cap. The factors that might make a Roth, traditional, SEP, or SIMPLE IRA a good fit are unique to you, your age, your income, your goals. Speaking with a tax professional and a financial planner about your situation will always be a safe bet when deciding which IRA to house your investments of choice. They can help you make sure you play by all the rules of the arrangement and don't overlook anything. But one thing's for sure. The advantages of saving into an IRA early and often are truly too good to pass up.

      (both) And that's our Two Cents.

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      What if there were a way to dodge taxes on a chunk of one's paycheck? Or how about an investment opportunity that will never pay a penny of taxes on the growth no matter how big it gets? Sound too good to be true? This is the amazing tax shelter of the IRA. Part of the "Two Cents" series.

      Media Details

      Runtime: 6 minutes 26 seconds

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