IRA Basics
The Individual Retirement Arrangement (IRA), also known as an Individual Retirement Account, is a single person, tax deferred savings account for employed people and their spouses. IRA’s are offered by most financial institutions, including banks, insurance companies, brokerage firms and mutual funds. Investment options for IRA funds are varied and the terms and conditions of the IRA will also vary depending upon the type of IRA. Traditional and Roth IRA’s, and their variations, are the preferred types. IRA’s have rules governing the maximum allowed contributions and penalties for early withdrawals.
The maximum allowed annual contribution to an IRA for the year 2007 is set at $4000 by the IRS. Barring unforeseen changes, the maximum for the year 2008 will be $5000. Persons aged 50 or above are allowed to make catch-up contributions of $1000 ( for 2007 and 2008 ), in addition to the maximum allowed contributions.
There is no minimum or required amount that needs to be contributed to an IRA, and all earnings are tax deferred until withdrawal. In the case of a Roth IRA, even withdrawals may be tax free, under certain conditions. Contributions to a Roth IRA are not tax deductible, while contributions to a traditional IRA may be tax deductible depending on the contributor’s tax status, participation in employer sponsored qualified retirement plans and the adjusted gross income. A working spouse without a qualified retirement plan is allowed tax deductible contributions of up to $2000 annually to an IRA, even if the other spouse is a participant in an employer’s qualified retirement plan.
If non deductible contributions are made to a traditional IRA, a part of any withdrawal from the IRA becomes non-taxable. The exact calculations, and the formula, for coming up with accurate figures for non-taxable withdrawals is outside the scope of this article, but filling out Form 8606 along with your tax returns will help resolve this issue. Please note that the IRS charges a 10% penalty for early withdrawals before age 59 ½ , except under certain conditions, such as death or disability. All withdrawals are taxed at ordinary income tax rates. Withdrawals are mandatory for traditional IRA owners who reach age 70½, failing which an excise tax of 50% is applicable on undistributed amounts. A Roth IRA has no mandatory withdrawal age limit, and the owner can keep on contributing as long as the owner’s taxable income funds the contributions.
Which IRA is suitable for you will depend on your employment, age, dependents and financial resources. A Roth IRA allows full withdrawal of both principal and earnings after age 59½ without having to pay any further taxes, since the initial contributions to Roth IRA’s are not tax deductible.
Due to the variety of IRA’s available (at least 11) and the highly complex nature of constantly updated IRS regulations which decide the exact tax benefits as per your individual situation, it is advisable to consult with your financial planner to determine exactly what kind of IRA you need, how much you should contribute each year and what you can expect from the account. You should also keep track of any changes in tax regulations and allowed contributions related to IRA’s, or at least make sure your financial planner keeps you updated.