There are different ways of putting money aside for your retirement. You can put money in the bank monthly, make investments, or open an IRA. But what is an IRA? It stands for Individual Retirement Account. An IRA is a way of saving up for your eventual retirement. It can either be tax-free or tax-deferred depending on the type of account you choose.
Types of IRAs
There are several types of IRA accounts to choose.
- Traditional IRA lets you contribute up to $5,000 every year, more once you hit 50, which you can apply as a taxable-deduction when filing for your income tax return. This makes your tax liability lower. You can withdraw money from your traditional IRA but it becomes subject to income tax. If the money is taken out before you reach the age of 591/2 years old, an additional penalty of 10% is applied. The only exception to this is if the money is used to purchase a home or to cover for approved higher education expenses. The 10% penalty is waived in these two instances.
- Roth IRA, established in 1997, is meant to aid middle-class Americans. Named after Senator William V. Roth, Jr. this IRA is not for high-level earners. There is a ceiling as to how much income you should be earning in order to avail of this type of IRA. For those eligible, this is more flexible than traditional IRAs even though this type is not tax-deductible. There is no penalty or tax when money is withdrawn from the Roth IRA. Only the interest that has been earned is taxed. After the fifth year, you can withdraw your contributions as well as the interest earned without being taxed or penalized.
- Simplified Employee Pension (SEP) IRA is more of a group retirement plan that lets an employer of a small business or self-employed one contribute to his employees' traditional IRA plan. This is in lieu of contributing to the employee's pension fund.
- Simple IRA is similar to a 401(k) plan wherein the employee and employer can both make contributions. The contribution limits are lower and the administration is simpler.
- Self-Directed IRA allows the plan holder to "make investments on behalf of the retirement plan."
Opening an IRA
Most banks and brokerage houses provide IRAs. You can open one in-person or even online. You will need your Social Security number as well as the numbers and addresses of potential beneficiaries of your IRA.
Deadline for contribution
IRA contributions are associated to a particular calendar year. You can make a one-time contribution or smaller ones based, the amount of which depends on the type of IRA you selected. Contributions begin on January 1 until the deadline for filing your tax return for a particular year.
Distribution from IRAs
When you reach the age of 70 ½, you are required to withdraw from your traditional IRA. The Internal Revenue Service (IRS) determines the minimum distribution amount that they base on your life expectancy.
What is an IRA? It is basically a retirement savings plan. Depending on the type of IRA you choose, there are certain restrictions to the amount you can contribute, possible tax implications, penalties that can be incurred as well as eligibility requirements. Still, you can get big tax breaks as you stash some cash for your twilight years. Find out more about IRAs in a Primer found in Smart Money or use their free Smart Money IRA Calculator to see which type of IRA is best for you.