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WIKI ANALYSIS
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This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it. |
This article is about traditional Individual retirement accounts (IRA), for other types or IRAs look at IRA (Disambiguation).
An individual retirement account (IRA) is a type of retirement plan in the US which protects retirement savings from taxes on growth, same as a Roth IRA. There is an additional cost/benefit if there is an increase/decrease in the marginal tax rate between contribution and withdrawal. (See Discussion Page). Unlike an employer managed plan, such as the 401k or a pension plan, an IRA offers a lot more flexibility in terms of investing choices. The account holder can use the money in the IRA to invest in all types of financial securities: such as stocks, bonds and mutual funds.
Contributions to this account can be (if you meet certain requirements) tax-deductible. This means that if someone puts in $2,000 into an IRA account and is in the 25% tax bracket, his tax liability decreases by $500. Transactions in the account, such as interest, dividends, and capital gains are not subject to tax. However, the person has to keep his money in the IRA account till the age of 59 and will face a penalty for withdrawing early (there are some exceptions). Withdrawals are subject to federal taxes.
The maximum annual contribution to IRA accounts are limited to $5,000 ($6,000 for people over the age of 50) or total annual income, whichever is lower. For example: If a person (age 30) puts $3,000 into a Roth IRA account, he can only put another $2,000 into a traditional IRA. In the case of married couples, each spouse is eligible to contribute individually.
Eligibility
- The regular IRA is not open for everyone. Individuals can only contribute to his account till the age of 70½. However, if the contributor is older than 70½, he or she may contribute to a nonworking spouse's IRA if the spouse has not reached 70½.
- A person is eligible to participate in an IRA even if she is participating in a retirement plan sponsored by her employer (such as a 401(k) and 403(b)).
- The maximum contribution is limited to $5000 per year for individuals below the age of 50, and at $6,000 for individuals above 50. However, these limits are reduced for people who earn less than these amount in "compensation", i.e. contributions to the IRA must come from "compensation" earned during the year.
- The amount an individual can contribute to a IRA is reduced by two other contributions:
- Contributions to a Roth IRA (except for conversion contributions)
- Contributions to a "501(c)(18) plan", which are employee funded pension plans created before June 25, 1959
- Contribution to SEP IRA or SIMPLE IRA do not reduce the amount one is eligible to contribute to a Roth IRA, unless it is a regular "IRA-type" contribution.
401(k) vs. IRA
- IRAs offer lot more flexibility in terms of investments. Not only does an investor have more options through an IRA, he can also change his investments positions much more easily (and frequently) in an IRA account than in a 401(k).
- There is no hassle of rolling over an IRA plan from one employer to the next.
- The maximum limit for 401(k) plans are substantially higher than the limit for IRA. In 2008, individuals under 50 were allowed to contribute $15,500 to 401(k) plans, whereas they could only contribute $5,000 to an IRA.
- Employers make matching contributions to 401(k), however there is no such provision for the IRA.
- An individual can borrow money from the 401(k) without paying a penalty, but not from an IRA. The borrowed money from a 401(k) is not treated as an income but has to be paid back with interest.
How to Start an IRA
IRAs are managed by custodians. Custodians can be any type of financial institutions which offer IRA accounts. Banks, insurance companies, mutual funds and brokerage firms are all valid IRA custodians. A person can walk into any of these institutions and fill up a form to start an IRA account.
Advantages of an IRA
- See the Discussion Page for the true benefits proved by math. The following is the received wisdom, but not accurate.
- Tax Benefit: An individual gets immediate tax benefit by investing through an IRA account since contributions to the account are tax deductible.
- Additional tax benefit accrues from the fact that the person may be in a lower tax bracket during retirement than while he is saving up for retirement.
- Protection from Bankruptcy and creditors: Up to $1,000,000 of IRA assets are exempt from a bankruptcy under the US bankruptcy code. Many states also have laws that prohibit judgments from lawsuits to be satisfied by seizure of IRA assets. However, the protection does not normally apply in the case of divorce, fraud, failure to pay taxes, and deeds of trust
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