If you have or are thinking of establishing an IRA, give yourself a pat on the back. A great resource for retirement, an IRA allows you to enjoy the benefits of compounding growth and tax savings. But the language of finance sometimes makes simple concepts seem more complicated. Here are 10 must-know IRA terms.
1. Adjusted gross income, or AGI
Used to calculate federal income tax, your AGI includes all the taxable income you received over the course of the year, such as wages, interest, dividends and capital gains, minus things such as business expenses, contributions to a qualified IRA, moving expenses, alimony and capital losses, interest penalty on early withdrawal of bank CD certificates and payments made to retirement plans such as SEPs and Simple IRAs.
2. Individual retirement account, or IRA
IRAs are retirement accounts with tax advantages. There are two types of IRAs, a traditional IRA which, for some people, provides a tax deduction, and a Roth IRA (more on this account later). Regardless of the type of IRA, your investment grows tax-free until you begin making withdrawals, usually after age 59½. If you take money out before then, you could be hit with a 10 percent penalty unless you meet certain specific requirements.
3. Retirement plan contribution
As long as you earn money, you can make retirement plan contributions to an IRA. If you're age 50 or older, you can make additional contributions. But your contributions, regardless of age, can't exceed your earned income. Contributions are classified as either tax deductible or nondeductible.
4. Deductible or nondeductible
Contributions to a traditional IRA are tax deductible if you are not covered by your employer's retirement plan. Even if you do participate in a company pension or 401(k) plan, you still may be able to deduct contributions to a traditional IRA depending on your income and filing status. Contributions to a Roth IRA are not deductible.
5. Modified adjusted gross income, or MAGI
For the purpose of determining your contribution limit, some people use their MAGI. For most people, this will be the line on your taxes that says "adjusted gross income," or AGI, but some taxpayers will have to modify their AGI by adding back some income or tax breaks. These add-backs range from foreign income you didn't have to count in your adjusted gross income to interest income for Series EE bonds that you used to pay for qualified educational expenses to a deduction for student loan interest or a traditional IRA contribution.
6. Required minimum distribution
Generally, if you have a traditional IRA, you must begin taking money out of the account by April 1 of the year after you turn 70½. The amount is a minimum distribution determined by your age and life expectancy. The IRS has established simplified tables that a traditional IRA owner can use to determine the required minimum distribution. If required payments are not made on time, the IRS will collect an excise tax. Roth IRAs aren't subject to minimum distribution requirements until after the Roth owner dies.
This is the term used when reinvesting assets from one tax-deferred retirement plan to another within 60 days. Generally, 20 percent of the funds is withheld for tax purposes if you take possession of the funds. You can avoid this by doing a direct rollover, which is a trustee-to-trustee transfer from one retirement account to another.
8. Roth IRA
The most notable thing about a Roth is withdrawals are tax-free if the account has been open for at least five years and you're at least 59½ when you start to withdraw money. Contributions to a Roth are not tax deductible. "You can withdraw your contributions anytime you want, no penalty or taxes," says Barry Picker, CPA with Picker & Auerbach. You can also withdraw earnings for a qualifying event if the account is at least five years old. Qualifying events include: death or disability of the account holder and a first-home purchase.
9. Tax and penalty-free withdrawals
You can take money out of your IRA tax-free and penalty-free as long as you repay the full amount within 60 days, but may only do it once in a 12-month period. The withdrawal proviso was intended to make IRAs portable, says Picker. "It's not for short-term loans." But some account holders use the rule to make loans to themselves. And many financial planners caution against it. The situation is "fraught with the potential for missing the deadline, not having the money and having a taxable event," says Peggy Cabaniss, CFP and president of HC Financial Advisors. A short-term IRA loan "would be my last resort," she says.
10. Education IRA
This account was years ago renamed Coverdell Education Savings Account, or ESA, in honor of the late Sen. Paul Coverdell, but you still hear the term education IRA pop up. This is not strictly an IRA, since it doesn't finance retirement, but when it was created, the general rules reminded folks of an IRA, hence the nickname. Instead, you make annual contributions, of up to $2,000 per child, to a Coverdell ESA to help pay education costs. You can't deduct the Coverdell contributions from your income taxes, but earnings are tax-deferred and qualified withdrawals, for certain school costs from elementary school to college, are tax-free.
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- Adjusted gross income
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