Individual retirement accounts, or IRA's were established by the U.S. Government to encourage saving. An individual who deposits part of current earning in an IRA does not have to pay income taxes on the earning deposited, nor are any income taxes charged on the interest earned by the funds in the IRA. However, when the funds are withdrawn from the IRA, the full amount withdrawn is treated as income and is taxed at the individuals current income tax rate. In contrast, an individual depositing in a non-IRA account has to pay income taxes on the funds deposited and on interest earned in each year but does not have ot pay taxes on withdrawals from the account. Another feature of IRA's that is different from standard saving account is that funds deposited in an IRA cannot be withdrawn prior to retirement, except upon payment of a substantial penalty. (LO2)

1. Sarah, who is five years from retirement, receive a $10,000 bonus at work. She is trying to decide whether to save this extra income in an IRA account or in a regular savings account. Both accounts ear 5% nominal interest, and Sarah is in the 30% tax bracket in every year (including her retirement year). Compare the amounts that Sarah will have in 5 years under each of the 2 saving strategies, net of all taxes, IS the IRA a good deal for Sarah?

1. Would you expect the availability of IRA's to increase the amount that households save? Discuss in light of (1) the response of saving to changes in the real interest rate and (2) psychological theories of saving.