“IRA” stands for Individual Retirement Account, with the key word being “Individual”, as the defining characteristic of an IRA is that it is for a single person and is not provided by the government (eg. Social Security) or by an employer (eg. 401(k)).
A Brief History of Retirement Accounts
Not long ago, there were only three basic types of retirement plans, the government-provided Social Security program, public sector pension plans, and company-specific pension plans.
The short-comings of the Social Security system have been well documented. Contribution amounts and limits are rigid, there is neither control or transparency as the how an individual’s deposits are invested, the payout is generally the same for all regardless of how much was contribution over one’s life. The fund is now under-funded, with ever increasing risk of reduced payouts to future retirees.
Company-specific pension plans ran into troubles in the 1970’s and 1980’s when corporations found that they could layoff senior employees just prior to becoming vested in the program such that the pension they had been relying on was taken away from them. Further, these were the days when someone might work for the same company their entire life. These plans weren’t designed to be portable and a voluntary job change usually resulted in a forfeiture of all future pension benefits. And, finally, not all employees were invited to participate, leaving most of the work force dependent solely on the Social Security program.
Enter the New Wave of Retirement Plans and Accounts
To address the loudening cries for better alternatives, a new generation of retirement plans and accounts have been created to meet the needs of today’s worker. Some of the main needs to be met included:
- No commingling of funds,—an individual saves to an account in their name and their name only.
- Individual control over how savings are invested.
- Savings are preserved and portable in the event of job change, job loss or company closure.
- Anyone can participate, even if their employer doesn’t provide a savings plan.
- Special considerations to allow for early access to savings, such as accessing the funds for a home purchase or early withdrawal in the event of hardship.
Fast-forward to today and we see a large number of options that meet most or all of the above listed needs to varying degrees, depending on the rules and requirements of each specific plan. There are plans for business owners and employees, there are plans for individuals, there are plans for the self-employed. With added variety has come added complexity.
Enter the Traditional IRA
Who Can Contribute to a Traditional IRA?
Any U.S. taxpayer with earned income can contribute to a Traditional IRA. The account is intended for those who cannot participate in an employer-sponsored retirement savings plan, such as a 401(k), though there are exceptions, so it is important to consult a professional to understand the eligibility requirements for your specific needs. In general, the tax-deductibility of contributions to the Traditional IRA account are phased out when household contributions are also being made to an employer-sponsored retirement plan.
How Much can be Contributed to a Traditional IRA?
In 2014, the contribution limit is $5,500 if under age 50 and $6,500 if over age 50. These limits do not apply to rollovers and transfers. These limits may also change from year to year, so it’s important to always check for the latest figures.
As long as the account holder does not participate in an employer-sponsored retirement plan, there are no earned income limits restricting how much can be contributed each year. No matter how much you earn in a year, you can always contribute the maximum allowable. (Note: a Roth IRA does have income limits.)
Age Restrictions Associated with Contributions
Contributions can be made up to the age of 70 1/2 years of age.
Tax Deductibility of the Contribution
When the rules are followed, the entire contribution is tax-deductible (your contribution is deducted from your income when determining your annual taxable income). In addition, it is also call “tax-deferred”, because taxes will eventually be paid when the money and earnings are withdrawn from the account at retirement.
Tax-Deferral of Earnings within the Account
In addition to the tax-deferral of the annual contributions, all earnings (eg. appreciation, interest income, dividends, etc.) grow within the account tax-free. Eventually, though, when withdrawals are made, income taxes are paid on the withdrawn amount, meaning both the portion that was originally an untaxed contribution as well as the portion that was previously untaxed earnings are eventually taxed as ordinary income.
When are Contributions to be Made?
Contributions must be made on or prior to April 15 (i.e. the tax filing deadline) of the year following the tax year for which the contribution is intended. No extensions of this deadline are allowed.
What Portion of the IRA Contribution is Tax-Deductible?
When the rules are followed, 100% of the contribution is tax-deductible. Note, as mentioned above, that there are conditions when contributions can be made that are not tax-deductible, or are partially tax-deductible. An example would be when someone in the household is also participating, or even eligible to participate, in an employer-sponsored retirement plan. You may still be eligible for a tax-deduction in these cases, depending on filing status and and whether or not you fall within certain income thresholds. It is important to consult a professional to know what rules apply to your specific situation.
How Can I Invest the Savings?
This is where extreme caution must be exercised when opening an Individual IRA. For example, if opened directly with a mutual fund provider, the account is often limited to only those funds provided by that specific company. When the account is opened, for example, with an independent financial advisor, the account will have access to a much broader palette of investment types,—mutual funds, stocks, bonds, ETF’s, CDs, money market funds and more.
Note that in the event where you may already have an Individual IRA with limited investment options, you are likely eligible to create a new account with the help of an independent financial advisor, and then transfer funds (“roll over”) from the old account into the new account WITHOUT disturbing its tax status.
When Can I Access the Money?
Technically, money can be withdrawn at any time, though if withdrawn early, an early-withdrawal penalty must be paid. The program is designed such that penalty-free withdrawals can be made starting at the age of 59 1/2. Further, withdraws must be made starting at 70 1/2 (according to a schedule, called Required Minimum Distribution, or RMD).
How are Withdrawals Taxed?
There are three age ranges to consider. Withdrawals made at age 59 or under are subject to a 10% penalty and subject to ordinary income tax rates. From age 59 1/2 to age 70 1/2, withdrawals are penalty-free and taxed as ordinary income. At age 70 1/2 and above, withdrawals must be made as required by law, and are penalty-free and taxed as ordinary income.
Can I borrow money from a Traditional IRA?
No, money cannot be borrowed from a Traditional IRA and the account cannot be used as collateral against loans.
What Happens to the Account Upon the Account Holder’s Death?
Upon death of the account holder, assets in the account can be passed on to the designated beneficiaries. It is always advised to seek qualified professional assistance in selecting your account beneficiaries.
Some Other Advantages of a Traditional IRA
A Traditional IRA may be eligible for conversion into a Roth IRA (though a Roth IRA cannot be converted to a Traditional IRA). In certain situations, a Traditional IRA protects wealth from creditors. When contributions are tax-deductible, you get to keep and grow that portion of your contribution that would have normally been paid in income taxes until distribution much later in life – when ideally your tax rate could be lower than when your earned it.
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What is a Traditional 401(k)?
What is a Roth 401(k)?
What is a Roth IRA?
What is the difference between Traditional and Roth 401(k)s and IRAs?
401(k) rollover options when making a job change