What is an IRA?
Over the past 25-30 years, the United States Federal Government has put into place tax incentives for Americans to save for their own retirement. For employees of larger companies, 401K and 403B accounts were introduced to allow people to save on a tax-deferred basis through their employment, while also receiving some matching portion that is offered by many employers. For individuals who work for employers that are unwilling or unable to offer a qualified 401K or 403B account, the Federal Government introduced Individual Retirement Accounts (IRAs), also on a tax-deferred basis.
Traditional IRAs are offered to any individual who earns some type of qualifying income during the tax year, but has no access to qualified 401K or 403B accounts. Qualifying income is generally defined as salaries, hourly wages, commissions, bonuses, alimony (taxable), tips and fees. In the case of a married couple, both parties can open an IRA as long as one of them has qualifying income. Individuals can contribute as much as they want into their IRA, however, tax-deferred limits for the 2014 tax year are $5,500 for individuals and $11,000 for married couples. (Note: Individuals 50 years-old or older who are opening a new IRA are permitted to make an additional “catch-up” contribution of up to $1,000 in 2014.)
Individuals with access to employer sponsored retirement accounts can also open a Roth IRA, which is allowed with after-tax dollars. However, the rules governing a Roth IRA contribution are a bit different. For instance, individuals earning $114,000 or less are allowed to invest up to a cap of $5,500 ($181,000 or less and $7,000 for married couples). The contribution cap begins to dwindle between income levels of $114,001-$129,000 for single individuals ($181,001-$191,000 for married couples), reaching zero at the highest level.
It is very important to understand the rules governing IRA withdrawals since they might trigger taxable events.Traditional IRA
- Withdrawals can be made at anytime, but must begin by age 70 1/2 years of age.
- All withdrawals of pretax contributions are subject to income taxes based on the individual’s current tax rates.
- If withdrawals are made from an account that has both pretax and after-tax contributions, the IRS provides a complicated calculation to determine how much will be taxable.
- All earnings on all contributions are taxable when withdrawn.
- Withdrawals made prior to the age of 59 1/2 are subject to a 10% penalty, unless the withdrawal is made for one eight reasons that carry exceptions: owner’s disability, owner’s death, withdrawn as part of an annuity, medical expenses that exceed 7.5% of AGI, medical insurance premiums if unemployed more than 12 weeks, first-time home purchase, college tuition or back taxes.
- Withdrawals can be made at anytime without any mandatory distribution dates.
- All earnings on contributions are tax-free, even when withdrawn (*See “Five-Year Rule”).
- * “Five year rule” – Any withdrawal of earnings prior to the age of 59 1/2 and sooner than five years from the initiation date of the Roth IRA are subject to a 10% penalty, plus the earnings lose tax-exempt status and become subject to normal income tax calculations. (Note: the exception rules also apply on Roth IRAs if withdrawn before age 59 1/2, but the same protection is not offered if the withdrawal violates the five-year rule).
If one of these retirement investment accounts seem appropriate, it is worth the time invested for every eligible individual to do the appropriate research and consider IRAs as a viable retirement savings options for a secure future.