Basics of IRAs
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 When you retire, and, it is hoped, are in a lower tax bracket, the money is taxed as it's withdrawn.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.
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. However, depending on your income, some or all of your contributions might not be deductible. The earnings, however, grow tax-deferred.
You may withdraw money -- it's called taking distributions -- at any time. However, under most situations you’ll be hit with a 10 percent early withdrawal penalty if you take money out before age 59½. 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.