Basics of IRAs

Bankrate.com

When you're saving for retirement, the nest egg builds a lot faster if you can put off paying taxes until you retire and are ready to withdraw your money. Uncle Sam gives taxpayers a few ways to do this.

Some accounts, such as a 401(k) or a company-sponsored individual retirement account, give you a double benefit. You can contribute pretax dollars to your account, which probably means you can save more than if you could only contribute after-tax dollars. And, you can deduct your contributions from your gross income, so you're paying less in taxes. When you retire, and, it is hoped, are in a lower tax bracket, the money is taxed as it's withdrawn.

Other accounts, such as a Roth IRA, only allow you to contribute after-tax dollars, but your earnings grow tax free. In other words, you don't have to pay taxes when you take the money out.

In this section, we'll look at some of the most popular tax-advantaged retirement plans.

Tax-advantaged retirement plans
  • Individual retirement accounts
  • Traditional IRAs
  • Roth IRAs
  • Self-directed IRAs
  • SEP-IRA, or simplified employee pension, plans
  • SIMPLE, or savings incentive match plans for employees, IRA

Individual retirement accounts

Individual retirement accounts, or IRAs, give people a way to build tax-deferred savings for retirement. An IRA is an account, not an investment. You can put just about whatever investments you want into your IRA -- stocks, CDs, mutual funds, cash and bonds -- anything except options and other derivatives.

The retirement formula for most employees these days no longer revolves around the promise of Social Security and defined-benefit or corporate-sponsored pension plans. Nowadays you're pretty much on your own, as most of corporate America has switched to "defined contribution" retirement plans.

"Defined benefit" means a company's plan guarantees eligible employees a specific payout, whereas "defined contribution" plans specify how much employees can contribute to a plan but don't guarantee a minimum payout. In other words, the burden of funding your retirement has shifted from your employer to you.

Traditional IRAs

Anyone younger than age 70½ with earned income -- whether the person works for someone else, is self-employed, a nonworking spouse or divorced and collecting alimony -- can open and invest in a traditional IRA, probably the most popular IRA.

There are income and contribution limits for traditional IRAs.

If you're not covered by a retirement plan at work, you can deduct your IRA contributions from your gross income for tax purposes. That's a big break because it lowers your adjusted gross income, or AGI, which means you pay tax on a lower income. On top of that, your earnings grow tax deferred until you withdraw them at retirement.

If you are covered by a retirement plan at work, you can still contribute to a traditional IRA, but the contributions are not deductible. The earnings, however, grow tax deferred.

You may withdraw money -- it's called taking distributions -- beginning at age 59½ as long as the account has been open for at least five years. If you opened the account at age 55, you'll need to wait until age 60 to take distributions. You must begin taking distributions by April 1 following the year in which you turn 70½.

A disadvantage of IRAs is that distributions are taxed as ordinary income even if the underlying investments have been held long term.

Since IRAs are meant for retirement, if you try to sneak out any funds prior to age 59½, with few exceptions, you'll get tagged with ordinary income taxes on the amount, plus, in most cases, an Internal Revenue Service penalty of 10 percent.

Generally, money can be withdrawn from a traditional IRA penalty-free before age 59½ to buy a first home, pay for higher education or extraordinary medical costs, or because of disability or death. (More on that in a later section.)

You may take a penalty-free loan from your IRA, but you'll need to replace the money within 60 days or pay taxes and the 10-percent IRS penalty.

Roth IRAs

There are several prominent differences between the traditional IRA and the Roth IRA. Contributions to a Roth are never tax-deductible, but the earnings grow tax free. You may withdraw your contributions at any time without penalty. In addition, there is no requirement that you take minimum distributions at any age.

In general, Roth contribution limits mirror the limits set for traditional IRAs. As long as you have earned income equal to the amount of your contribution and meet the income restrictions, you can open a Roth even if you have a traditional IRA and an employer-sponsored 401(k).

The Roth IRA is a convenient way to give yourself access to tax-free money when you retire. If you're a smart investor and manage your account properly, you could reap an enormous windfall. Just about any brokerage firm, bank, credit union or mutual fund company will help you open a Roth IRA.

There are two ways to get a Roth started -- open a new account and fund it with new money or convert assets from a traditional IRA to a Roth. Converting a traditional IRA to a Roth means you have to first pay any taxes that are owed on the investments that will be converted. A key aspect when considering whether to convert a traditional IRA to a Roth is how you'll pay the tax on the earnings from the traditional IRA. The earnings will be taxed as ordinary income. If you need to use the IRA itself to pay the tax, it may not be a smart idea to convert. You don't have to convert your entire traditional IRA at once. You can do it piecemeal and just convert as much as you can comfortably afford to pay the tax on.

Self-directed IRAs

An IRA that is set up with a brokerage is said to be "self-directed." You have the responsibility of deciding how the money will be invested -- stocks, bonds, mutual funds, certificates of deposit, even real estate.

You can open a self-directed IRA with any brokerage. Just visit the brokerage's Web site and follow the instructions. The account can be funded with new money or, if you leave a company, you can arrange to have the proceeds from your company-sponsored retirement plan rolled over into an IRA. If you opt to do that, be sure the check goes directly from your company to the brokerage. If the check is made out to you, you could be liable for taxes and an early withdrawal IRS penalty. The brokerage will give you specific directions regarding how the check should be made out and where it should be sent.

SEP-IRA, or simplified employee pension, plans

These are company-sponsored IRAs that can be opened by the smallest of businesses, the sole proprietor. Under the SEP-IRA plan, an employer can contribute to his or her own retirement, or to an employee's existing IRA. In the case of an employee, the account is owned and controlled by the employee; the employer simply makes contributions to the financial institution where the account is held.

The penalties for early withdrawal remain the same as with the traditional IRA.

The employer receives the tax deduction for the contributions.

If you are a small-business owner, IRS publication 560, Retirement Plans for Small Business, explains the contribution limits for these plans.

SEP-IRAs give employers some flexibility. They don't have to contribute every year.

SIMPLE, or savings incentive match plans for employees, IRA

This is a company-sponsored plan that's designed for small businesses of 100 or fewer employees who make a minimum of $5,000 each. The plan can be set up at a designated financial institution or at an institution chosen by the employee.

A SIMPLE plan is a savings incentive match plan for employees in which the employer makes matching or nonelective contributions.



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