In Simple Terms: What is an IRA?
An IRA is not an investment in and of itself. Think of an IRA as a container that holds stocks, bonds, mutual funds, property or gold bars - anything that is considered an investment. The IRA "container" defines your tax benefit, with different types of IRAs having different tax benefits and different rules for contributions and disbursements. The investments in the IRA define the kind of returns you get on your contributions.
The two most popular IRAs are Traditional IRAs and Roth IRAs. Traditional IRAs are covered in this article.
Traditional IRA Income, Age and Contribution Limits
- Income Limits: There are no income limits for a nondeductible traditional IRA, but you or your spouse must have earned income or receive taxable alimony payments. Earned income is taxable compensation such as taxable salary and wages from your employer or self employment income. If one spouse does not have earned income, a Spousal IRA can be set up in the nonworking spouse's name with the income-earning spouse listed as the beneficiary.
- Age Limits: Currently, you must be under the age of 70-1/2 to make contributions to a traditional IRA.
- Contributions: Currently, you can contribute the lesser of your earned income or $4,000 for single filers and $8,000 for those filing joint returns.
Traditional IRA Deductions
- IRA Tax Deduction Clarification: The amount contributed to a traditional IRA is not deducted from your income tax liability. Rather, the amount of your contributions is deducted from your gross income. Your income is reduced, resulting in a lower income tax liability. You may be able to deduct all of your traditional IRA contribution, or only a portion, depending on your level of income.
- Deduction Amount: The amount you can deduct for a traditional IRA contribution changes regularly due to new tax laws which typically increase the deduction amount or the income level you can have and still take a deduction. The deduction allowed depends on whether you are filing a joint tax return, your income and your age.
- Employment Retirement Plans: If you or your spouse participates in an employer-sponsored retirement plan, the traditional IRA deduction may be reduced.
Traditional IRA Withdrawals
- Mandatory Withdrawals: You will be required to start taking withdrawals for retirement at a certain age, currently 70-1/2.
- Early Withdrawals: Pre-retirement withdrawals require you to pay taxes and a penalty. However, you can take hardship withdrawals for education costs, medical expenses and other situations. These withdrawals do not incur a penalty.
- Retirement Withdrawals: Traditional IRA withdrawals taken during retirement are taxed at your tax rate when you take the withdrawals. This works out well if your income tax rate goes down during retirement, but many people find a Roth IRA to be more advantageous.
Tax codes occasionally change so check with the financial institution you will open an IRA with, an accountant, IRS Publication 590 or contact the Internal Revenue Service for the most recent rules governing Roth IRAs before investing in one.
How is a Roth IRA Different from a Traditional IRA?
