Understanding Your IRA

Similar to an employer sponsored 401k, an IRA is a tax deductible defined contribution retirement account. It does not require an employer to be a sponsor and one can be opened at a variety of financial institutions.

As a retirement investment, an Individual Retirement Account (IRA) has multiple advantages and disadvantages:

Pros:
Tax deferred until withdrawal.
Individual, customized control of investments.

Cons:
Very low yearly contribution allowance of $5,000.
10% withdrawal penalty.
Lack of liquidity if the contributor needs the money for another purpose.


Benefits of an Individual Retirement Account (IRA)

The most significant advantage of an IRA is that it’s a tax deferred plan similar to a 401k. For example, if you are making $50,000 a year and opt to put the maximum of $5,000 a year into your IRA, your income rate for taxes will be considered $45,000. This tax deferment also means that when you withdraw the funds upon retirement, the withdrawn amount is taxed as income.

Owners of the account have a variety of investments that can be funded with their IRA account. These generally include a variety of stocks, bonds and mutual funds. Investments such as real estate have further limits set in place by the individual retirement account (IRA) administrator. Collectibles and life insurance are not permitted to be held in individual retirement accounts (IRA).

The tax deferment feature of an individual retirement account (IRA) is generally popular because individuals expect to have lower yearly income in their retirement years than in their working years. In this case, being taxed at their lower income rate during retirement can save money over being taxed at the higher income rate received during their working years.

Deposit Limits of an Individual Retirement Account (IRA)

The yearly deposit limit for an IRA is $5,000 in 2008 and 2009. There is an additional “catch-up” allowance of $1,000 a year for individuals 50 or older. There is a restriction on this catch-up contribution in that the owner must have already made the maximum contribution to their Individual Retirement Account (IRA) and an employer sponsored 401k. These deposit limits are also in place for a Roth IRA and the total deposit between two separate accounts can’t exceed the limits listed above.

Withdrawing funds from an Individual Retirement Account (IRA)

As with a 401k, there is an early withdrawal limit on individual retirement accounts (IRA) if the money is distributed outside of the allowable exceptions. The IRA is open to withdrawal once the owner reaches the ages of 59 ½. At the age of 70 ½ the owner is required to withdraw the minimum amount which is calculated as a combination of life expectancy of the owner, their spouse, and any beneficiaries.

Other exceptions to the penalty include:

Medical expenses that exceed 7.5% of the owners adjusted gross income.
Withdrawal in order to buy a first home.
Inability to work any longer (disability).
Costs of medical insurance while unemployed.
Distributions to a beneficiary if the owner dies.
Higher education expenses of the owner, their children or their grandchildren.


Types of Individual Retirement Accounts (IRA) Available

The above information is all in reference to a traditional individual retirement account (IRA). The following is a list of non-tradition IRAs available and how they differ from the traditional plan.

Roth IRA

The primary difference is that a Roth IRA is not tax deductible and the owner pays taxes on the money before it is deposited into the account. On the other hand, the money is not taxable once the owner begins to withdraw funds. Additionally, any capital gains, dividends, and interest earned in the account are not taxable. The Roth IRA also does not have a requirement to begin withdrawals by age 70 ½. There is a maximum yearly income allowed to be eligible to contribute to a Roth individual retirement account (Roth IRA). For full contributions this limit is $105,000 for single filers and $166,000 for those filing jointly.

SEP IRA

The Simplified Employee Pension Individual Retirement Account (SEP IRA) is an IRA account specifically meant for self-employed individuals and their employees. The account is shared among all members involved and uses a profit-sharing model. The contribution limits for an SEP IRA are the lesser of 25% of income or $49,000 in 2009. All members of the SEP IRA are required to make the same contribution.

Individual Retirement Accounts (IRAs) are popular among individuals who are looking to plan out their retirement. It is important when planning for retirement to understand the different options available and how to fit them into your personal preferences. You can read more about how an individual retirement account (IRA) fits into saving for retirement and retirement investing here.