Whether you are nearing the end of a Christian debt management program or simply wanting to begin planning for your retirement, one of the first things that you will likely be investigating is the Traditional IRA. Today we’re going to discuss the basics of the Traditional IRA and explore why it should be at the top of your list of methods for funding your retirement.

What is an IRA?

Let’s first break down the abbreviation- an IRA is an Individual Retirement Account.

There are several kinds of IRAs, such as a Roth IRA, a Simple IRA, and a SEP IRA. For the purpose of this article though, we are simply going to focus on the Traditional IRA.

For a very simple explanation, an IRA is an investment account that you can utilize to save funds for your retirement with a few tax benefits along the way.

What does an IRA actually do?

The IRA provides you with an account where you can deposit pretax money, currently up to $5,000 annually or $6,000 annually if you are over age 50. The increase is because you may need to save more as you get closer to your retirement. The money in that account can then be used to purchase investments such as stocks bonds etc. This is considered to be tax-deferred, because you will not pay your taxes on the money until you pull it out of the account.

That tax deferment is the primary benefit of the IRA. Let’s suppose you are a single filer and earn $40,000 per year; by todays standards you would fall into the 25% tax bracket. To pay taxes on $5000 (the max annual IRA contribution under 50) at this point in time would cost you 25% of that income, or $1250. The expectation is that when you retire, your income is going to be reduced pushing you into a lower tax bracket. Let’s say that your income has dropped from $40,000 per year to $30,000 per year; you are now in a 15% tax bracket and instead of paying $1250 for that $5000, it would instead be $750. If you are using the IRA to its full capacity and making the maximum annual contribution year after year, this can add up to a very significant tax benefit.

What happens Inside the IRA?

While you are funding your IRA, the money is not just sitting there earning no interest. Within the IRA you are able to purchase investments. Assuming your investments are wise you are likely to receive a return on your investments, and again the income earned on the investments are tax-deferred. Over the years of making your annual contributions and in turn earning a profits from investing those funds, you are not yet paying the taxes on the income.

The difference in the tax rate from when you are in the height of your career compared to being newly retired with a reduced income can cause a major flux in your income tax bracket. As that IRA account grows and the profits from your investments accumulate over the course of say 20 years, the tax savings brought about by being charged at a different tax rate can be very substantial.

What’s the catch?

Based on everything that we’ve shared with you so far it seems very clear that this is a smart thing to do when you are saving for your retirement and, generally, it is! However, there is one very important factor to consider before starting with this type of retirement savings- the early withdrawal penalty.

As is mentioned in its name, the IRA is a retirement account. As such, you cannot access the funds without penalty until age 59 ½. If you do withdraw from the account prior to this point you are going to not only pay the taxes on the amount that you withdraw but also incur a penalty, currently 10% of what is withdrawn. Every situation would certainly be unique, but generally the benefits of an IRA will be lost if the funds must be withdrawn at a penalty.

An IRA is a great investment tool that will provide a vehicle in which you can conduct your other investments. If you have created your emergency fund, paid off your credit card debt (on your own or through our Christian debt relief program) and are ready to begin planning for your retirement, this is one avenue you will definitely want to explore.