Traditional IRA

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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. 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 will be tax-deductible if you meet certain requirements. Transactions in the account, such as interest, dividends, and capital gains are not subject to tax. Money must be kept in the IRA account till the age of 59 or else they trigger early withdrawal penalties (there are some exceptions). Withdrawals are considered taxable income for 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.cash loans


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.
  • 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

  • Incentive to Save: The tax reduction resulting from contributions and added tax resulting from withdrawals creates an emotional incentive to save for retirement and not raid the account ahead of time.
  • 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
  • Tax Shelter: The benefit of the IRA equals the difference between the value of your account resulting from using an IRA vs. a taxable account. Three factors determine this benefit.
    • A benefit everyone receives equals the amount of tax you would have paid in a taxable account. This is the exact same benefit as from a Roth account.
    • If the marginal tax rate applied to the contribution is higher (lower) than the rate on the withdrawal there is a benefit (penalty) equal to the amount withdrawn multiplied by the difference in rates.
    • The recognition of income in retirement may reduce your eligibility for social benefits. The cost of this is usually calculated by considering the lost benefits as an additional tax when calculating the tax rate on withdrawal.
    • The original reduction in taxes from the contribution is NOT a benefit. It should be considered like a loan. On withdrawal you pay back the loan along with all the income that was earned by it.
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