An Individual Retirement Account (commonly know as an IRA) is a retirement savings account for U.S. workers. IRAs are useful in retirement planning because they provide various tax advantages, and some states even have laws to protect IRA accounts from lawsuits or creditors.
IRAs were first introduced in 1974. Over the years, many changes have been made regarding the eligibility of contributors and the maximum yearly contribution amount. There have also been several types of IRAs created since its inception.
Funds in IRA accounts can be used to invest in a variety of investment vehicles, depending on the brokerage. These investments can range from stocks and mutual funds, to CDs and bonds, and even (in some cases) real estate.
Types of IRAs
There are five main types of IRAs currently available for workers in the United States. Their differences lie mainly in how deposited funds are taxed, but other factors can differ as well. Types of IRAs include:
- Traditional IRA – Contributions are tax deductible (treated as non-taxable income), but withdrawls are taxed (treated as income). This is the oldest form of IRA.
- Roth IRA – Contributions to Roth IRAs are not tax-deductible (i.e. made with after-tax assets), but withdrawls meeting the minimum guidelines are almost always tax-free. Offers the most flexibility.
- SEP IRA – Allows an employer to contribute to a Traditional IRA account in an employee’s name. SEP IRAs are an alternative to a pension fund.
- SIMPLE IRA – A pension plan that allows for both employer and employee contributions. SIMPLE IRAs are similar to 401(k) plans, but are simpler from both a cost and administrative perspective. They’re also limited to “eligible employers” only.
- Self-Directed IRA – Offers contributors the most investment options, but normally the account must be keep with a trustee or custodian (which, of course, incurs fees).
Funding IRAs and Eligibility
Contributing to an IRA generally must be done with cash or cash equivalents. If you attempt to fund an IRA with a different type of asset, your fund may be disqualified from its beneficial tax treatment (which is the main reason for funding an IRA in the first place). There are also yearly contribution limits.
For 2015, the maximum a worker under 50 years old can contribute to an IRA is $5,500 (or 100% of your earned income, whichever is less). For those 50 and older, a special “catch up” clause applies; people in this age bracket are allowed to contribute $6,500 per year (or, again, 100% of their earned income, whichever is less). For example, if you’re under 50 and earned $50,000 in 2010, you may contribute $5,500. If you’re under 50 and earned $3,000, your contribution limit is $3,000.
Not everyone is eligible to contribute to an IRA, however, as there are income limits in place for both Roth IRAs and Traditional IRAs. So, if you earn more money than the given threshold for a given tax year, you’re not eligible to contribute to your IRA. You may still maintain the IRA, but may not fund it during a year in which you earn more than the specified limit.
Once you’ve established and funded an IRA account, you’ll need to decide how to invest your money. Some feel comfortable making their own investment decisions, while others will want those choices handled by a financial services professional.
The government places very few restrictions on how you can invest the money in your IRA, but certain items like collectibles (stamps, baseball cards, etc.) and life insurance are not permitted. Your broker or custodian may limit you to mainstream investment vehicles, however, such as stocks, bonds,and mutual funds, so be sure to screen brokers first to make sure they allow your personal investment of choice.
Your holdings within an IRA account grow tax-free. That means all interest, capital gains, and best of all, dividends, accumulate in your account without Uncle Sam getting to them.
Choosing the Right Type of IRA
The type of IRA you choose should be based mainly upon your tax preferences. If you’d like your contributions to be tax-deductible up front, then a Traditional IRA may be your best option. Most of the time, however, workers gain the most benefit from a Roth IRA, since withdrawls during retirement are not taxed. In essense, you can choose to pay Uncle Sam a little more now, or a lot later.
For the ultimate in flexibility with your IRA, you may choose a Self-Directed IRA, but beware: this type is generally more complicated and requires a custodian (who will charge you fees) or the establishment of an LLC (which is cheaper, but involves a lot more work).