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.
1. Adjusted gross income, or AGI— Used to calculate federal income tax, your AGI includes all the 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 SEP and SIMPLE IRAs.
2. Contribution— IRA contributions are limited to $5,000 for the 2008 tax year if you’re younger than 50. If you’re 50 or older, you can contribute as much as $6,000 for the 2008 tax year. The limits are the same for 2009. Contributions are classified as either tax deductible or nondeductible.
3. 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.
4. Education IRA— Renamed Coverdell education savings account, in honor of the late Sen. Paul Coverdell, this is not strictly an IRA, since it doesn’t finance retirement. Instead, you can make annual contributions, of up to $2,000 per child, to an account that’s exclusively for helping to pay education costs. The money you put aside in a Coverdell account doesn’t count against the annual retirement IRA contribution limits for you or your child. You can’t deduct the Coverdell contributions from your income taxes, but earnings are tax-deferred and qualified withdrawals are tax-free.
5. Individual retirement account, or IRA— IRAs are retirement accounts with tax advantages. You may contribute up to $5,000 in 2008. Or, if you’re 50 or older, you can put aside up to $6,000 for that tax year. But your contributions can’t exceed your earned income. The investment grows tax-free until you begin making withdrawals, usually after age 59½. Take money out before then and you will usually get hit with a 10-percent penalty unless you meet certain specified requirements.
6. 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,’ but for some people it has to be modified,” says Barry Picker, CPA with Picker, Weinberg & Auerbach. Some modifiers include foreign-earned income, housing costs of U.S. citizens or residents living abroad and income from sources within Puerto Rico, Guam or American Samoa.
7. 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 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.
8. Rollover— This is the term used when transferring assets from one tax-deferred retirement plan to another. In order to avoid any possible taxes when transferring a retirement account, don’t make the move yourself. Have the money transferred from one plan to another by the accounts’ trustees.
9. Roth IRA— The most notable thing about a Roth is withdrawals are tax-free if the account has been open for at least five years and you’re at least 59½ when you start to withdraw money. Contributions to a Roth are not tax-deductible. “You can withdraw your contributions anytime you want, no penalty or taxes,” says Picker. You can also withdraw earnings for a qualifying event if the account is at least 5 years old. Qualifying events include: death or disability of the account holder and a first-home purchase.
10. Tax and penalty-free withdrawals— You can take money out of your IRA tax-free and penalty-free as long as you repay the full amount within 60 days, but may only do it once in a 12-month period. The withdrawal proviso was intended to make IRAs portable, says Picker. “It’s not for short-term loans.” But some account holders use the rule to make loans to themselves. And many financial planners caution against it. The situation is “fraught with the potential for missing the deadline, not having the money and having a taxable event,” says Peggy Cabaniss, CFP. A short-term IRA loan “would be my last resort,” she says.