Interest compounds when the interest you earn on your principal earns more interest. When you create an Individual Retirement Arrangement, you benefit from compounding interest and tax-deferral serves to enhance that benefit.
Individual Retirement Arrangements
You can create your own retirement account by making annual contributions to an Individual Retirement Arrangement. You deposit gross, or pre-tax, earnings into a traditional IRA whereas you deposit net, or after-tax, earnings into a Roth IRA. Generally, as of 2011, you can deposit up to $5,000 into either type of IRA, and if you are 50 or older, you can deposit up to $6,000. The IRA designation just serves to separate the funds from your other money for tax reporting purposes. You must decide how to invest your IRA money, and some people opt to invest in interest-bearing accounts such as certificates of deposit or fixed annuities.
Both traditional IRAs and Roth IRAs provide you with a tax shelter. In a traditional IRA you do not pay taxes on your investment earnings until you actually withdraw money from the account, and in a Roth, you may never pay taxes on it if you meet distribution requirements. Consequently, not only does your interest compound, but the fact that you are not pay taxes while it is growing means that your money grows even faster than in an interest-compounding taxable account. Alternatively , if you invest in mutual funds, stocks or other types of marketable securities, you could reinvest dividends to the same effect. However, the value of these investments can rise or fall. For this reason, some investors choose to invest more in interest-bearing accounts as they near retirement.
Required Minimum Distributions
When you reach the age of 70 1/2, you must begin to make withdrawals from your traditional IRAs. The amount that you must withdraw depends upon your marital status and your life expectancy as shown on annually published Internal Revenue Service life expectancy tables. Failure to take the RMD leads to a tax penalty equal to 50 percent of the withdrawal amount. Therefore, some people choose not to allow their IRA CDs and other types of interest paying IRAs to compound. Instead, they instruct the IRA custodian to disburse the interest earnings so that they can satisfy the RMD requirements.
You can quickly grow your savings by making annual contributions to an IRA. However, to make sure that taxpayers do not use IRAs simply for short-term gains, the IRS imposes tax penalties on premature IRA withdrawals. If you withdraw funds from an IRA before reaching the age of 59 1/2, then you pay a 10 percent tax penalty on top of regular income tax. On a Roth, you only pay the tax and penalty on your earnings, but you also pay it regardless of age if you cash in a Roth that you have owned for less than five years. Despite benefits such as compound interest, IRAs can prove costly if you end up using the money before you reach retirement age.
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