An individual retirement account or IRA is a vehicle designed to help you reach your retirement goals. Federal legislation created the tax deductible IRA, later known as the Traditional IRA, in the 1980's for U.S. citizens with earned income. Since then, Congress has made numerous changes to the law, including the addition of the Roth IRA. Because of this, you need to continue to be aware of current policy, how it affects your tax deductions, whether income growth is tax-free, and if penalties apply for early withdrawal. Eligibility, income limits and other factors that affect your ability to participate in an IRA can change annually. Be sure to check this year's IRA Publication 590 or 560 for the most up to date information. Changes for 2012 include higher income limit cap increases, higher contribution limits, and an expansion to eligibility for the Saver's Tax Credit for lower income individuals.
Types of IRA Accounts
There are five main types of IRAs: Traditional, SIMPLE, SEP, Rollover, and Roth. IRAs are broken down based on how they work, who can buy them, and how much you can contribute.
Traditional IRA
A Traditional IRA is for people under age 70 ½ with earned income. Funds in the account are tax deferred until withdrawal, which must begin by April 1 of the year following the year in which you reach the age of 70 ½.
- Your contributions to a Traditional IRA are tax deductible.
- Contributions and interest are tax deferred.
- Withdrawal of contributions, plus interest is taxed as income.
In order to claim a tax deduction for contributions to any Traditional Individual Retirement Account, you must use Form 1040.
SIMPLE IRA
Short for Savings Incentive Match Plan for Employees, the SIMPLE IRA is a form of traditional IRA established by small companies for employees.
- Your contributions to a SIMPLE IRA are tax deductible.
- Contributions and interest are tax deferred.
- Employers often match contributions within set limits.
- Withdrawal of contributions, plus interest is taxed as income.
Retirees often pay a lower tax rate. Combine this advantage with tax savings received at the time you make your contributions and a SIMPLE IRA can prove to be a valuable tax management tool.
SEP IRA
Another form of traditional IRA, the Simplified Employee Pension IRA is typically established by a self-employed individual for himself and for his employees.
- If you are self-employed, you may take a tax deduction for SEP plan contributions for yourself and for contributions you make for your employees.
- Contributions and interest are tax deferred.
- Employees do not pay taxes on SEP contributions made by their employer.
- Withdrawal of contributions, plus interest, is taxed as income.
- If you set up an SEP IRA you must establish a Traditional IRA and deposit contributions into it.
While both employer and employee can contribute to a SIMPLE IRA, only the employer can contribute to an SEP IRA.
Rollover IRA
A Rollover IRA is a special temporary IRA used to receive distributions from an employer sponsored qualified plan such as a 401(k) or profit-sharing plan and transfer them to another qualified retirement plan.
- Typically, you must transfer funds out of the Rollover IRA within 60 days.
- You will not pay taxes on the funds as long as you do not withdraw them.
- You must deposit (rollover) the funds into a qualified retirement plan, which could be an IRA, a new employer 401(k), 403(b), or 457 plan.
A Rollover IRA is not a retirement vehicle. It is a temporary place to put retirement funds when transferring them from one type of retirement account to another.
Roth IRA
Roth IRAs are similar to traditional IRAs, except that contributions come from after-tax earnings.
- Your contributions to a Roth IRA are not tax-deferred.
- Interest is not taxed.
- Withdrawal of contributions, plus interest is not taxed.
Since Roth IRAs allow you to put money into an account where the growth escapes federal tax, your contributions add up after years of tax-free compounding. Furthermore, since withdrawals are tax-free, your retirement tax rate is not an issue.
Eligibility
Traditional
If you have taxable earnings or self-employment income and will not reach age 70 ½ by the end of the year, you may establish and fund a Traditional IRA.
There are income limits and other rules that determine how much, if any, of your contributions are tax deductible.
Simple
If your employer offers a SIMPLE IRA plan and you received at least $5,000 in compensation during any two years preceding the current calendar year, and expect to receive at least $5,000 during the current calendar year, you can participate in the company's SIMPLE IRA.
SEP
If you are self-employed or an employee of a company that offers a SEP IRA plan, you can set up or participate in a SEP IRA plan, provided you meet the stated eligibility requirements.
- You meet the age requirement (usually 21 or older).
- You must have earned the established wages ($550, for example).
- You must have worked for the employer (or yourself) for any three out of the last 5 years.
Rollover
If you have money in a retirement account, you are eligible to establish a Rollover IRA for transferring that money to another retirement account.
Roth
If you have taxable compensation or self-employment income for the year, you may establish and fund a Roth IRA, subject to the following limits:
- If you are single and have income of more than $125,000 in 2012, you are not eligible to open a Roth IRA. For the most current information, check the IRS website.
- If you are married, the income limit is $183,000.
Contribution Limits
Each IRA has its own contribution limits. The following numbers are based on the tax year 2012, for the most current limits please check the IRS website.
- Traditional - If you are age 50 or older, you can contribute up to $6000 to a Traditional IRA.
- Simple - You can contribute up to $14,000 to your employer's SIMPLE IRA plan if you are 50 or older.
- SEP - As a self-employed business owner, you can contribute up to 25 percent of your gross income, up to a maximum of $50,000 to your SEP IRA. You can contribute the same amount for each of your employees.
- Rollover - There is no limit on contributions transferred to a rollover IRA.
- Roth - If you are 50 years of age or older, contributions made to Roth IRAs are the lesser of your taxable compensation for the year or $6,000.
Withdrawal
Traditional - SIMPLE - SEP
If you begin withdrawing money from your Traditional, SIMPLE, or SEP IRA after the age of 59 ½, you will pay taxes on the amount you withdraw as if it was regular income.
If you withdraw funds before the age of 59 ½, you will probably pay a penalty in addition to taxes.
You do not have to withdraw funds from any of these IRAs until you reach the age of 70 ½. At that time, you have to withdraw a certain percentage each year.
Rollover
When it comes to withdrawing funds, your Rollover IRA is treated the same as a Traditional IRA. Since it is temporary, you will eventually have to either roll it over or withdraw the funds.
Roth
The Roth IRA has special rules. No taxes will be due on withdrawals, provided you have had the funds in the account for at least five years and you are at least 59 1/2 when you begin withdrawing the funds.
You are not required to begin withdrawing funds from a Roth IRA at any time - even when you reach age 70 ½.
Deadlines
All Individual Retirement Accounts have the same deadline. You can contribute as late as the first tax return due date, typically April 15 each year.
In addition, these contributions can be retroactive to the previous tax year. This means you can make an IRA contribution April 15 of one year and have it apply to the previous year.
Make an Informed Investment
It's important to do your research when you're looking into retirement funding. Find out how much you can contribute, and whether or not you qualify. It is also a good idea to work with a certified financial planner so you can figure out how much money you need to contribute for a comfortable retirement.
