Individual Retirement Accounts: Why Bother?
by William K.
September 22, 1996
Thesis: When planning for retirement, Individual Retirement Accounts offer
several benefits; however, careful planning is essential to ensure that: upon
retirement there is an adequate amount of money saved, that the heirs to the IRA
are chosen carefully, and that unnecessary taxes and penalties are avoided.
I. Upon retirement there is an adequate amount of money saved.
A. How much money necessary to retire?
1. Social Security verses retirement.
2. Savings Accounts verses retirement.
3. Advantages of starting an IRA early.
II. Careful selection of the heirs to the Individual Retirement Account.
A. Advantage of leaving IRA to spouse
1. Special rights as a spouse.
2. Different options the spouse has for claiming money.
III. Avoiding unnecessary taxes and penalties.
1. Recoverable trust as beneficiary.
2. Taking money out before the age of 59 1/2.
3. Penalties for leaving money in too long.
Many people often live their lives without considering how they plan to
retire. People do not realize that the idea of living solely on the benefits of
social security is not realistic. In order to secure a comfortable future,
people must have some type of additional income. Sacrificing a small amount of
money into an IRA at a relatively early age could make a considerable difference
in the lives of people upon retirement. When planning for retirement,
Individual Retirement Accounts offer several benefits; however, careful
planning is essential to ensure that: upon retirement there is an adequate
amount of money saved, that the heirs to the IRA are chosen carefully, and that
unnecessary taxes and penalties are avoided.
It is important to consider how much money will be needed for a comfortable
retirement. Careful planning is essential when considering an item with such
importance. Phaneuf states that, according to figures used by most financial
planners, upon retirement the average person will need roughly seventy percent
of their current income to continue living their present lifestyles (94). With
only income from Social Security and money saved in bank accounts, most people
are unable to achieve this goal. Furthermore, one must also consider, for a
retirement account to be effective the account has to maintain interest rates
above that of inflation. Inflation increases approximately four percent
annually; and standard bank accounts barely beat this rate. In fact, at present,
most savings accounts have an interest rate below four percent. Thus, regular
savings accounts are not a practical method to save for retirement; however,
IRA’s offer deferred taxes on the interest earned until the money is withdrawn
from the account. Therefore for a given amount of money, there is a
considerable advantage when saving in an IRA. For example, according to Heady:
if you were to save $2000 dollars a year at 6% for 30 years under the terms of a
regular savings account, the total earnings would be approximately $120,900
after paying taxes; however, if you were to shelter $2000 a year at 6% in an
Individual Retirement Account that amount would increase by $48,000 dollars to a
total of $168,000 because of the tax-deferred feature (60).
Using this example, the tax deferred feature of an IRA is easily recognized
as having a considerable edge over regular savings plans.
Another advantage to consider when planning an IRA is to start the account
as early in life as possible. It is obviously an advantage to use the program
that is going to give the best overall return; however, the advantage of
starting early should not be taken lightly either. As with all savings plans, a
key factor in the final results is the overall length of time that has been
exhausted investing into the account. People often think that there is an age
requirement to start an IRA; however, this is not the case. There are several
Banks that will even allow teenagers under the age of eighteen to begin an IRA,
as long as their parents cosign. The results of starting as a teenager are
astonishing. According to Spears: if a 15-year-old were to begin saving $2,000
a year in an IRA for ten years and earns 10% a year, the compounded annual
return on the Standard ; Poor’s 500-stock index for the past 60 years. Barring
early withdrawals, that $20,000 investment would be worth more that $1.5 million
at age 65 (55). It is easy to see that the earlier the account is started, the
more interest eared over the years on the account, and the more financial
stability that will be established at retirement. In addition, starting early
also allows the holder to start off investing less money; thus taking off some
of the burden of having to invest larger amounts of money into the IRA at later
ages. Keep in mind, This is a small price to pay to gain financial security
for the rest of your life.
There are also several items that must be determined when establishing an
IRA. Among the most important, is careful selection of the beneficiaries. When
leaving assets to a spouse, things are very simple because the spouse has
special rights as an IRA beneficiary. For example, a spouse that has reached
the age of 59 1/2 and wants to utilize the money in the account can remain as a
beneficiary. By leaving the account under the name of the deceased, the spouse
can begin withdrawing the money as a life-time allotment. The spouse also has
the option of taking the money out over the next five years following the
original IRA owner’s death.
Rowland states that the other alternative is for the spouse to convert the
IRA to his or her own name. Under these terms all of the regular IRA rules will
apply. The spouse will then be able to change all conditions under which the
original IRA was opened. For example the beneficiaries can be changed, money
can continue to be invested into the account, and the spouse may select
different mutual funds if so desired (59). The disadvantage of this method is
that unless the spouse wants to pay a ten percent penalty, the money will be
locked under IRA terms until the he/she reaches the age of 59 1/2. Generally if
the money is left to the spouse, under normal circumstances and provided he/she
outlives the original holder, most of the major penalties should be avoided.
In addition, when opening an Individual Retirement Account one should
become very familiar with the rules and regulations. Many people leave their
IRA practically untouched only to have their heirs lose the majority of it to
taxes and penalties; however, if you understand the rules, most of these
penalties can be avoided. To avoid paying these incredibly large taxes to the
Internal Revenue Service (IRS), there are a few items one should understand.
For example, when an IRA is left to someone other than a spouse, the rules
change significantly. According to Rowland, If the IRA holder were to make the
unfortunate mistake of changing the beneficiary to a revocable trust, the
penalties are caustic. Immediately following the death of the original holder,
the IRA will cease to exist. Thus causing federal and state taxes to be due
immediately on the entire amount in the account (59). Therefore, If the IRA
were to have two million dollars in the account, using the normal income tax
rate of thirty percent, the value could shrink down to as little as $1,400,000.
A $600,000 penalty that could have been avoided. By leaving the account to a or
child, the IRA could have continued to exist tax deferred for several
generations; this strategy would also avoid the income taxes that would
otherwise be outstanding on the account.
Additionally if you take money out before the age of 59 1/2 you will
receive a ten percent penalty on top of the regular income taxes. IRA’s were
designed as a means to save for retirement, therefore, to avoid this penalty,
simply leave the money until after retirement. Sanders states that from the age
of 59 1/2 to 70 1/2 You may withdraw as much as you like or nothing, and pay
only the usual income taxes (unless the withdrawals are so large you owe a 15%
savings penalty) (202). It is a good idea to leave the money in an IRA for as
long as possible; however, Sanders further explains: that there are also
penalties for leaving the money in too long. When the holder reaches the age of
70 1/2 he or she must begin making annual withdrawals. Except for the first
year, for which you get a three month grace period, the deadline for each years
minimum withdrawal is Dec 31. So if you turn 70 1/2 on June 30, you must make a
1995 withdrawal by April 1, 1996, as well as a 1996 withdrawal by Dec, 31 1996.
Withdrawing less than required in any year will cause a 50% penalty on the
amount of the shortage (202). It is significantly important to stay educated
about all of the possible penalties and keep track of all significant dates.
The small print could actually cost up to several thousands of dollars in
needless penalties, and the only one responsible for this knowledge is the IRA
An Individual Retirement Account is a program that should be considered by
all families. As long as careful planing is done, the heirs are chosen
carefully and care is taken to avoid the taxes and penalties, most will find
that IRA’s are excellent for planning retirement. Families growing in the
nineties must begin to look to the future and decide if the plan that they have
established is sufficient to leave them financially stable for the rest of their
lives. The cost of living is far above the level of when one could plan to
retire solely on the benefits of Social Security. As times pass, many major
companies are beginning to no longer offer the type of benefits that once could
support a family after retirement. Therefore, It is a must that we start taking
the steps necessary to ensure our own futures are filled with the dreams and
livelihood we all desire.
Heady, Christy. Your complete guide to tax-free income. Consumer Digest
Nov-Dec. 1995: 22.
—. How to retire with financial security. Consumer Digest. Sept-Oct. 1995:
Phaneuf, Anne M. Start saving before it’s too late (retirement savings).
Sales and Marketing Management April. 1996: 94.
Rowland, Mary. With big IRA’s a wrong move can be costly. Nations Business
Dec. 1995: 59.
Saunders, Laura. Endgame (IRA account management; includes related articles
on taxation of such accounts). Forbes 19 June.1995: 202.
Spears, Gregory. Making kid stuff out of IRA’s (for yo