- What they are: An individual savings account with tax incentives.
- Pros: Tax benefits - investments grow tax-deferred and contributions may be deductible; variety of investment options with wide range of risk/reward characteristics.
- Cons: Early withdrawal penalties plus you may have to pay income tax on the amount; limits on annual contributions; eligibility restrictions.
- How to invest: Directly through financial institutions including banks, mutual fund companies and brokerage firms.
An IRA can be thought of as a savings account that has tax benefits. You open an IRA for yourself - that is why it is called an individual retirement account. If you have a spouse, you will each have a separate IRA. An important distinction to make is that an IRA is not an investment itself; rather, it is an account where you keep investments such as stocks, bonds and mutual funds. You get to choose the investments in the account, and can change the investments if you wish. There are several types of IRAs, including traditional, Roth, SEP and SIMPLE. In many cases, you can have more than one type of IRA as long as you meet certain requirements.
Traditional and Roth IRAs
The primary difference between traditional and Roth IRAs is when you pay taxes on the money that you contribute to the plan. With a traditional IRA, you pay taxes when you withdraw the money during retirement. With a Roth IRA, you pay taxes when you put the money into the account. The money grows tax free while it’s in either a traditional or Roth IRA.
Another difference between traditional and Roth IRAs is who can contribute. With traditional IRAs, almost anyone with earned income can contribute. With Roth IRAs, however, your income may prevent you from contributing. Ordinarily, you are able to contribute to a Roth IRA if your modified adjusted gross income is (current for tax year 2013):
- Less than $188,000 if you are married, filing jointly
- Less than $127,000 if you are single, head of household, or married, filing separately (and did not live with your spouse during the previous year)
- Less than $10,000 if you are married, filing separately and you lived with your spouse at any point during the previous year
For 2013, you can contribute the smaller of $5,500 or your taxable compensation for the year to traditional or Roth IRAs.
SEP and SIMPLE IRAs
Simplified Employee Pension IRAs, or SEP IRAs, are a type of traditional IRA for self-employed individuals and small business owners. You can open a SEP IRA if you are a business owner with one or more employees, or if you are an individual with freelance income. All employees must be included in the SEP if they are at least 21 years old, have worked for your business for three out of the previous five years, and if they have received at least $550 in compensation from your business. Contributions are tax deductible (for the business or individual) and go into a traditional IRA in the employee’s name, and employees are fully vested at all times. For 2013, contributions cannot exceed the lesser of 25% of the employee’s compensation or $51,000. Catch-up contributions are not permitted.
A SIMPLE IRA (Savings Incentive match Plan for Employees) is an IRA set up by a small employer for its employees. Unlike a SEP IRA, employees are allowed to contribute to SIMPLE IRAs. Eligible and participating employees can make salary reduction contributions up to a certain amount; for 2013, the employee can "defer" up to $12,000. In turn, the employer must make either a matching contribution up to 3% of your salary, or a nonelective contribution of 2% of your compensation.
Required Minimum Distributions
Individual retirement accounts, including traditional, Roth, SEP and SIMPLE IRAs, are subject to required minimum distributions (RMDs). In general, you must make withdrawals before April 1 of the year following the year you turn 70.5. For all subsequent years, you must take the RMD before December 31 of each year.
How much you are required to take depends on the account balance and your age. In general, the RMD is calculated by dividing the prior end-of-year balance by a life expectancy factor that is published in Tables in IRS Publication 590, Individual Retirement Arrangements. You will use a different table depending on your situation; for example, you would use the Joint and Last Survivor Table if your sole beneficiary of the account is your spouse, and he or she is more than 10 years younger than you are.
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