IRAs, or individual retirement accounts, are retirement savings accounts you set up and manage on your own or with the help of a financial adviser.
You open an IRA by filling out a relatively simple application provided by the brokerage firm, bank, mutual fund company, or other financial services company you choose as the custodian of your account, and by making an initial contribution.
The only requirement is that you have earned income — money you get for work you do. You qualify whether you work full- or part-time. And you can add to your IRA even if you're contributing to a retirement plan at work, such as a 401(k) or a 403(b), or a Keogh plan if you're self-employed.
There's an annual cap on IRA contributions, whether you choose a tax-deferred IRA or a Roth IRA or split your contribution between the two. In 2016 the limit is $5,500. You can contribute as much as you want, up to that cap, but you can't contribute more than you earn. If you're over 50, you can also make an additional catch-up contribution of up to $1,000.
Types of IRAs
There are three types of IRAs: traditional deductible, traditional non-deductible, and Roth. All three make it easier to accumulate retirement savings because they provide tax breaks.
Both traditional IRAs are tax deferred, which means you don't owe income tax on any earnings that accumulate until you withdraw money. Roth IRAs are tax free, which means you owe no tax at all on your earnings even when you withdraw, provided you follow the rules that apply.
In return for these tax advantages, you agree to leave your IRA assets in your account until you're at least 59½. If you withdraw before then, you may owe a penalty as well as the taxes due on the amounts you withdraw.
The difference between a deductible and a nondeductible traditional IRA is whether you qualify to subtract your annual contribution from your gross income when you file your income tax return. If you qualify, your IRA is deductible. If you don't, it's not.
You can deduct your IRA contribution if you qualify on either of two grounds:
- Your modified adjusted gross income (MAGI) is less than the annual maximum set by Congress;
- You're not eligible to participate in a retirement plan at work.
In 2016, you qualify to subtract your entire contribution if you have a modified AGI of up to $61,000 if you're filing a single tax return and up to $98,000 if you're filing a joint return. You may qualify to subtract part of your contribution if you're single and your MAGI is less than $71,000. If you're filing a joint return, you can deduct a portion of your contribution up to a MAGI of $118,000.
You can always deduct your full contribution if your employer doesn't offer a retirement plan, or if you don't qualify to contribute. Either way, there's no limit on the amount you can earn if you’re single. But if you’re married and file a joint return, you’re eligible to deduct the full amount if your joint MAGI is up to $183,000, and a gradually smaller percentage until your MAGI reaches $193,000.
However, once you turn 70½, you can't make any more contributions to a traditional IRA, even if you're still working. In fact, you must start taking mandatory withdrawals.
Roth IRAs resemble traditional nondeductible IRAs. You can make an annual after-tax contribution up to the limit set by Congress and pay no income tax on the earnings.
There are important differences, though, that make Roth IRAs especially appealing. Your earnings are tax free when you withdraw, provided you're at least 59½ and your account has been open at least five years. The entire amount is yours to spend as you wish. And there are no required withdrawals. And, if you continue to earn income, you can keep on contributing — even when you're 90.
In 2016 you're eligible to contribute up to the annual cap to a Roth IRA if you're single and your MAGI is less than $117,000. If your MAGI is between $117,000 and $132,000, you can put a decreasing portion of your IRA contribution into a Roth, and the balance into a nondeductible traditional account if you choose. If your MAGI is greater than $132,000, you're not eligible for a Roth.
If you're married and filing a joint return, you can contribute the full amount if your MAGI is less than $184,000, and a gradually decreasing amount up to $194,000.
You need to earn income to qualify to open an IRA. But there's an exception for nonworking spouses. If your husband or wife doesn't work and you do, you can open a separate account for your spouse, called a spousal IRA.
The 2016 contribution limits are the same for traditional and Roth IRAs. Catch-up contributions also apply. So if your spouse is over 50, you can put in an extra $1,000. You must file a joint tax return any year either of you puts money in a spousal IRA.
Your family income will determine if you can select a Roth IRA or a traditional IRA for the spousal account. And your income and eligibility for a retirement plan at work determine whether you can deduct the contribution to a traditional IRA on your tax return.
Even though you make the contributions to a spousal IRA, the account is in your spouse's name. He or she can choose how to invest the money and can start withdrawing from the account at age 59½ without penalty.
Choosing an IRA
If you qualify for all three types of IRAs, you'll have to choose. Traditional deductible IRAs have the strictest adjusted gross income (AGI) limits, while traditional non-deductible IRAs have none. Roth IRAs are in between, though the majority of workers qualify.
There are no hard and fast rules for which is the best choice, but many experts advise choosing a Roth if you qualify, because of the advantage of eventual tax-free income.
Whichever type you select, you'll want to keep good records — and hang on to them. If you can't prove your IRA's status, you could end up paying taxes twice, once on your contribution to a non-deductible IRA and again when you withdraw the principal..
Traditional non-deductible IRA
Traditional deductible IRA
No required withdrawals
No age limit for contributing
Tax deductible contributions
Contributions not deductible
Contributions not deductible
Tax due on earnings at regular rates at withdrawal
Required withdrawals beginning at 70½
Tax due on contribution plus earnings at regular rates at withdrawal
Required withdrawals beginning at 70½
Investing in your IRA
You can invest your IRA contributions almost any way you wish.
For example, you might buy individual stocks and bonds, mutual funds that invest in stocks, bonds, or a combination of both, or real estate investment trusts (REITS). The only limitations are that you can't buy collectibles, art, gems, or non-US coins.
The tax-deferred difference
What's sometimes confusing is that you can own identical investments inside and outside an IRA. The difference is that earnings on the investments in the IRA are tax deferred or tax free — depending on whether it's a traditional or Roth — and earnings on non-IRA investments are taxable.
Because IRA earnings aren't taxed, you can sell investments in the account that have increased in value and use your gain to make additional investments. You don't owe tax on the capital gain, although you may owe transaction costs.
Choosing IRA investments
The same principles of asset allocation and diversification important to your overall investment portfolio apply to your IRA. If all of your assets are invested in stocks, your account may lose value in a stock market downturn. Or, if you keep all your money in cash, your account value may be eaten away by inflation.
However, because you owe tax at your regular income tax rate on traditional IRA withdrawals, some experts suggest holding long-term growth investments, such as new-company stocks, in regular taxable accounts. You can keep the investments as long as you want, you won't owe tax unless you sell at a profit, and if you've held the stock for a year or more, you'll owe tax at the lower long-term capital gains rate. Of course, if you own these assets in a Roth IRA, you won't owe any tax at all.
Similarly, experts suggest you avoid investing in municipal bonds within an IRA. If you include them in a traditional IRA, you'll eventually owe income tax on the interest they pay, even though that interest would have been tax free if you had owned the bonds in a taxable account.
And while the interest would be tax free in a Roth IRA, municipal bonds generally pay at a lower rate than comparably rated corporate bonds.
You generally have until April 15 to open your IRA for the previous year and make your contribution.
Rollover IRAs are like deductible traditional IRAs — your contributions and earnings grow tax deferred, and when you withdraw you pay tax at your regular rate on the full amount you withdraw. But unlike a traditional IRA, which you build by making annual contributions, a rollover IRA is funded with money that's already been put away in a qualified retirement plan, like a 403(b). The rollover lets you move the money without owing any tax at the time of the move.
You might move the assets in your 403(b) or other retirement plan into a rollover IRA if you retire, change jobs, or if a plan is disbanded and the money is paid out. With an IRA, you have more control over how the money is invested and how you manage withdrawals. However, you may pay higher fees than you do with an employer’s plan.
Rules for IRA rollovers
If you follow the rules for rolling over an employer-sponsored retirement plan, you'll postpone paying taxes and avoid early withdrawal penalties.
- Arrange a direct transfer.
Ask your employer or the trustee of your existing account to transfer your assets directly to your new IRA account. You do have the option of getting a check and handling the rollover yourself, but if you choose that approach, your employer must withhold 20% of the total for income taxes. You'll eventually get that money back, but only if you meet the deposit deadline.
- Deposit within 60 days.
If you get a check from your employer, you must deposit the full amount into your new rollover IRA within 60 days. That means not only the 80% you receive, but the 20% that was withheld. Any amount that's not deposited within the 60-day limit loses its tax-deferred status.
- Keep IRAs separate.
You should keep your rollover IRA separate from any other IRAs you might have. Otherwise, you may not be able to move the money into a new employer's retirement plan.
- Don't mix taxed and pretax money.
You can move only pretax contributions made to a pension or retirement fund into a rollover IRA. If you've made after-tax contributions, or if your employer has made supplemental contributions that aren't tax deductible, that money has to be invested separately.
- Put away pension payouts.
Whether your pension payout is made in one lump sum or a series of partial lump sums over a period of less than ten years, you can put the money into a rollover IRA.
Withdrawing from IRAs
The benefits of traditional IRAs come with tradeoffs.
When you make withdrawals, any earnings are considered regular income and are taxed at your regular federal income tax rate. If you deducted the contributions you made, tax is due on the entire withdrawal.
The fine print
If you withdraw before you're 59½, you may face an additional 10% penalty on the amount. And you're required to start taking regular withdrawals when you turn 70½. If you take too little in any year, you could incur a 50% penalty on the amount that you didn't withdraw.
Surprisingly, there are fewer restrictions on Roth IRAs. No federal income tax is due if you're at least 59½ when you withdraw, provided the account has been open at least five years. And there are no mandatory withdrawals.
That means you can manage your finances to suit yourself, or use your account to build an estate for your heirs. But you should discuss your plans with your tax or legal adviser.
The benefits of tax-free income are hard to beat, and they only get better as your income tax rate rises. For example, if you were single, had a marginal tax rate of 25%, and withdrew $40,000 in one year, you would have about $8,000 more if the money came out of a Roth account than out of a traditional IRA.
Early IRA withdrawals
In some situations, you may be able to take early withdrawals from a traditional IRA without owing the 10% penalty. For example, you can use an unlimited amount of IRA money to pay college tuition or medical expenses. And you can withdraw up to $10,000 to buy a first home for yourself, your parents, or your child. You will still owe the federal income tax that applies to the withdrawal amount, however.
With a Roth IRA, you can always withdraw your contributions without tax or penalty before you turn 59½ since you've already paid tax on them. And you can withdraw up to $10,000 without penalty if you use it to purchase a first home. However, you can't make penalty- or tax-free withdrawals for tuition or medical expenses.
Since these rules are complicated, you'll want to consult your financial or tax adviser before making withdrawal decisions.
Required minimum distributions
Though you can withdraw from your traditional IRA without penalty any time after you turn 59½, you don't have to begin mandatory withdrawals — officially known as required minimum distributions (RMDs) — until the year following the year you turn 70½.
When you reach that milestone, you must calculate the correct amount of your distribution by dividing your account balance at the end of the previous year — usually December 31st — by a uniform withdrawal factor that's based on your life expectancy. For example, at age 70, you divide by 27.4, at age 71, you divide by 26.5, and at age 72, you divide by 25.6. (The number gets smaller as you get older, but not a full year smaller for each year you age.)
The custodian of your account will report your account balance, and you can find your withdrawal factor in IRS publication 590 or from your financial or tax adviser. You have until the following December 31st to withdraw.
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