An IRA is an Individual Retirement Account. An IRA can be referred to as an investment vehicle. If you think of an individual stock, bond, or mutual fund as a passenger, an IRA is the automobile that the passenger rides in. You can choose from a wide variety of investments to ride in an IRA vehicle. The primary advantage of IRAs is the tax savings typically associated with them. Different IRAs have different tax advantages and are often used as the primary vehicle for investing for retirement.
There are four different types of IRAs:
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
1. Traditional IRA: This is probably the most common IRA. For the 2010 tax year IRS regulations allow a maximum contribution of $5,000 to a traditional IRA and Roth IRA combined. The amount can either go all to one IRA or be split between a traditional and Roth IRA. If you are 50 years of age or older, the combined contribution maximum is $6,000, a bit larger to help you get ready for an approaching retirement. Contributions are tax deferred, meaning that you can take an income tax deduction for your contributions in the year you make the contribution and pay the tax on that income and its earnings later. When you withdraw funds from an IRA later in life, you pay income tax on those distributions (withdrawals) and the gains they have earned. The tax advantage is that you get to deduct the contribution, but when you receive the distribution, you may be in a higher tax bracket. The maximum contribution may also be reduced based on your adjusted gross income (AGI), filing status, and other circumstances.
Distributions are also governed by rules and exceptions to those rules. Distributions are subject to your current income tax rate and are also subject to a 10% penalty if withdrawn before reaching the age of 59 1/2.
A 401(k) account can also be rolled over into a traditional IRA because the tax treatment is the same (tax deducted at the time of contribution and paid at the time of distribution).
2. Roth IRA: A Roth IRA is a similar vehicle to a traditional IRA with the same combined contribution limit of $5,000, as noted above, or $6,000 if you are 50 years of age or older. Contributions are also subject to the same AGI limitations. The primary difference is the tax treatment as contributions are not tax deductible. The tax advantage, though, is that the distributions received from a Roth IRA, as well as any gains those contributions earn, are not taxable. The taxes are paid in the year of the contribution (because it is not tax deductible) rather than in the year of the distribution, as is the case with a traditional IRA. Even though you miss out on the tax deduction, you may pay less tax on the contribution than you would on the distribution if you are in a higher tax bracket at the time of the distribution. I personally like the tax advantages of a Roth IRA and knowing that the earnings growth and distributions are tax-free.
Distributions are also subject to a penalty of 10% if taken before reaching age 59 1/2 or if withdrawn within five years of opening the Roth IRA.
3. SEP IRA: A Simplified Employee Pension (SEP) IRA is an employer established and funded SIMPLE IRA and is often used by small business employers in place of a 401(k). Employers can contribute directly to employees’ traditional IRA accounts, or sole proprietors can contribute for their own benefit. The tax advantages and early distribution penalties are the same as a traditional IRA.
4. SIMPLE IRA: Savings Incentive Match Plan for Employees (SIMPLE) IRAs are retirement plans sponsored and administered by employers, which allow employers to contribute up to $11,500 (limit for 2010). These can also be used for sole proprietor's benefit. The tax advantages and early distribution penalties are the same as a traditional IRA. The penalty becomes 25% if the distribution is within two years of first participating in the SIMPLE IRA plan.
As noted, these are the basics for understanding IRAs as an investment vehicle for retirement. The IRS regulations regarding IRAs are considerably more extensive but mostly apply to special circumstances and exceptions to the general rules. These basics can assist in finding the right retirement account for you.