If you have or are thinking of establishing an IRA, give yourself a pat on the back. A great resource for retirement, an IRA allows you to enjoy the benefits of compounding growth and tax savings. But the language of finance sometimes makes simple concepts seem more complicated. Here are 10 must-know IRA terms.
1. Adjusted gross income, or AGI
Used to calculate federal income tax, your AGI includes all the taxable income you received over the course of the year, such as wages, interest, dividends and capital gains, minus things such as business expenses, contributions to a qualified IRA, moving expenses, alimony and capital losses, interest penalty on early withdrawal of bank CD certificates and payments made to retirement plans such as SEPs and Simple IRAs.
2. Individual retirement account, or IRA
IRAs are retirement accounts with tax advantages. There are two types of IRAs, a traditional IRA which, for some people, provides a tax deduction, and a Roth IRA (more on this account later). Regardless of the type of IRA, your investment grows tax-free until you begin making withdrawals, usually after age 59½. If you take money out before then, you could be hit with a 10 percent penalty unless you meet certain specific requirements.
3. Retirement plan contribution
As long as you earn money, you can make retirement plan contributions to an IRA. If you're age 50 or older, you can make additional contributions. But your contributions, regardless of age, can't exceed your earned income. Contributions are classified as either tax deductible or nondeductible.
4. Deductible or nondeductible
Contributions to a traditional IRA are tax deductible if you are not covered by your employer's retirement plan. Even if you do participate in a company pension or 401(k) plan, you still may be able to deduct contributions to a traditional IRA depending on your income and filing status. Contributions to a Roth IRA are not deductible.
5. Modified adjusted gross income, or MAGI
For the purpose of determining your contribution limit, some people use their MAGI. For most people, this will be the line on your taxes that says "adjusted gross income," or AGI, but some taxpayers will have to modify their AGI by adding back some income or tax breaks. These add-backs range from foreign income you didn't have to count in your adjusted gross income to interest income for Series EE bonds that you used to pay for qualified educational expenses to a deduction for student loan interest or a traditional IRA contribution.
6. Required minimum distribution
Generally, if you have a traditional IRA, you must begin taking money out of the account by April 1 of the year after you turn 70½. The amount is a minimum distribution determined by your age and life expectancy. The IRS has established simplified tables that a traditional IRA owner can use to determine the required minimum distribution. If required payments are not made on time, the IRS will collect an excise tax. Roth IRAs aren't subject to minimum distribution requirements until after the Roth owner dies.