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Most of us put April 15 behind us with a big sigh of relief. The way tax laws change all the time, keeping everything straight on your returns is a challenge even for professional accountants -- let alone rank-and-file taxpayers like us.
But over decades of major tax law changes, at least one great tax break has stuck around for investors. This year marks the 35th anniversary of the IRA -- meaning that for some, this valuable tool has guided them from the beginning of their careers all the way into retirement.
From humble beginnings
Back in 1974, Congress created IRAs as an alternative to employer-sponsored retirement plans. The idea was that if you were covered at work, you didn't need an IRA; but if your employer didn't offer some type of retirement plan, then you could fund your own IRA as an alternative. The original contribution limit was just $1,500.
Over time, though, IRAs became a much more important part of an overall retirement plan. By the 1980s, tax laws allowed workers to have both an employer-sponsored plan and an IRA. Also, the law recognized the need to provide for nonworking spouses by allowing them to make modest contributions to their own IRAs.
Inflation, however, made IRAs play a less significant role in retirement savings over time. Contribution limits of just $2,000 applied all the way up to 2001, when legislation started the clock on raising them to $5,000 and indexing the amount to inflation.
Where the real money is
After 35 years of accumulating assets, IRAs now play a pivotal role in retirement planning. According to the Investment Company Institute, 47 million households held $4.5 trillion in assets within IRAs as of mid-2008. That now represents about a quarter of all retirement assets.
Why the big ramp-up? Certainly, not all of that money came from $2,000 and $5,000 annual contributions. Rather, a number of factors have contributed:
- Over time, companies such as General Motors (NYSE: GM ) , Ford (NYSE: F ) , and FedEx (NYSE: FDX ) have used buyouts to reduce traditional pension liability and phase workers into early retirement. Although the tax implications vary greatly depending on the terms of the buyout, some employees were able to take money their employers offered and roll it over into IRAs.
- Anyone with funds in a 401(k) who has left their job can also do a rollover into an IRA. Given that 401(k)s have higher annual limits, they mark a substantial source of funds for IRA growth over time. In addition, with controversies over 401(k) fees and investment choices -- controversies that have sparked lawsuits against big employers like Wal-Mart (NYSE: WMT ) , Boeing (NYSE: BA ) , and Deere -- many prefer to get out of 401(k) plans as soon as possible.
The next step
The real challenge for many is figuring out how to manage their IRAs in retirement. When these accounts represent the bulk of your savings, you have to be smart in what you do with them. Here are a couple of tips:
- Watch the taxes. If you have a traditional IRA, money you take out will typically get taxed at your regular rate. That has a huge impact on how much you have to withdraw in order to support spending. For instance, if you're taxed at a 33% rate and want $100,000 in usable cash from your IRA, you have to take out almost $50,000 extra just to pay tax. Even the money you pull out to pay taxes gets taxed, which can make your overall tax bill balloon up fast.
- Invest smart. The tax deferral that IRAs offer gives you great benefits -- but only if you use them. So keep high-tax investments like REITs or high-yield bonds in an IRA, while saving your taxable account for low-tax stocks like Apple (Nasdaq: AAPL ) or Cisco Systems (Nasdaq: CSCO ) , neither of which pays any dividends at all.
- Think forward. Make sure you have beneficiaries named on your IRA. After you die, the tax benefits of that IRA can continue for decades if you take care of all the administrative work on the front end.
For 35 years, IRAs have helped in the quest for a secure retirement. Use them well, and they'll become an important part of your overall financial plan.
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