The benefit of a traditional IRA is that the contributions are tax-deductible in the year the taxpayer makes the contribution.

For example, the taxable income for a couple is $90,000 in 2011 and each spouse contributes $5,000 in a traditional IRA. They will be able to deduct the contributions from their income taxes. Thus, they will pay tax on $80,000 in income to the IRS.

Assuming the couple is in the marginal 25 percent tax bracket (Federal) and their IRA contributions are $10,000, they will save $2,500 in Federal income taxes in 2011.  The earnings generated by a traditional IRA are tax deferred. 

The tax deductible contributions and earnings are taxable as ordinary income when they are withdrawn from the account after age 59.5.  The IRS will assess a 10 percent early withdrawal penalty for distributions made before the farmer reaches age 59.5 from the IRA.

Like traditional IRAs, Roth IRAs offer tax-deferred earnings. Earnings grow tax-free. There is no tax upon withdrawal, so long as the taxpayer held the account for at least five years and is over the age of 59.5.

Contributions to a Roth IRA are never tax deductible. The taxpayer must have earned income equal to or greater than their contribution. In order to contribute to a Roth IRA, their Adjusted Gross Income (AGI) must be below certain income levels, e.g. $177,000 for married filing jointly or qualifying widow(er) in 2011. 

Withdrawals of earnings in a Roth IRA prior to age 59.5 are generally subject to ordinary income taxes and an additional 10 percent penalty.

IRA contributions can be used to purchase a variety of investments (stocks, bonds, certificates of deposits etc.) which are sold by banks, insurance companies, brokers and mutual funds. 

Tax advisors, loan officers and friends are excellent sources of references to find an investment advisor who will help the farmers meet their goals and risk tolerance. Frequently, investment advisors will discuss the topic of compound interest (return) with their clients in making a plan to invest IRA contributions.

Compound interest occurs when interest is earned on a principal sum along with any accumulated interest on that sum. In other words, you earn interest on interest. 

Time magnifies the effects of compounding. Thus, you will make more money the longer your investment is able to work for you.  Table 1 illustrates the impact of compound interest rates on the future value of a $5,000 deposit to an interest bearing account.  Example:  $5,000 invested today could increase in value ten-fold if invested for 30 years at 8 percent.

Table 1.  Future Value of a $5,000 Investment in an Interest Bearing Account

 

Interest Rates

Years

2%

4%

6%

8%

10%

5

$5,520.40

$6,083.26

$6,691.13

$7,346.64

$8,052.55

10

$6,094.97

$7,401.22

$8,954.24

$10,794.62

$12,968.71

20

$7,429.74

$10,955.62

$16,035.68

$23,304.79

$33,637.50

30

$9,056.81

$16,216.99

$28,717.46

$50,313.28

$87,247.01

40

$11,040.20

$24,005.10

$51,428.59

$108,622.61

$226,296.28

IRA accounts provide farmers the opportunity to diversify and invest in income- producing assets (e.g. certificates of deposit, mutual funds etc.), and not depend entirely on their farm assets for retirement income. 

Farmers who make IRA contributions early in their careers are afforded the opportunity to reap major increases in the value of their contributions through the impact of compound interest. 

Income tax savings may occur in either the current tax year or when withdrawn during the retirement years. 

For more information on IRA’s, see IRS publication 590 http://www.irs.gov/pub/irs-pdf/p590.pdf or contact your tax advisor.