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Individual-Based Retirement Saving: IRA's

An individual retirement arrangement (IRA) is a self-provided retirement plan account that provides tax advantages for retirement savings in the United States. Some people may choose to invest, gamble, or rely on their business to save for retirement. However, these types of investment/savings vehicles require you to invest with post-tax income. Once you reap the earnings or capital gains of these investments, you get taxed again on those earnings/gains. With an Individual Retirement Account, unless you make a non-qualified distribution (mostly related to withdrawing before you are allowed to), you will only be taxed once during this savings process, either before you deposit or after you withdraw your savings. This makes IRAs more attractive savings vehicles. However, there are limits to how much you can contribute tax-free annually through an IRA depending on your Modified Adjusted Gross Income (MAGI).

There are actually ten types of IRAs, but this article will be focusing on the more common IRAs: the Traditional IRA, Roth IRA, SEP IRA, and the SIMPLE IRA.

What is a Traditional IRA?

A Traditional IRA is an individually established plan that allows contributions to be made with pre-tax income. Once contributions are made to the account, the money within the account may be used towards different investment options, such as stocks, bonds, and mutual funds and allowed to grow. The traditional IRA offers tax-deferred savings; the portion of your income you put into the account is not taxed, but your withdrawals will be taxed when you withdraw it years later. However, when you withdraw money from a traditional IRA, you are taxed for both principal and gains as ordinary income. The Traditional IRA can either be an individual retirement account or an individual retirement annuity.

- In the United States, an individual retirement account is one of two types of the traditional IRA. It is a trust or custodial account set up for the benefit of you and your beneficiaries. Contributions must be made in cash, and money in your account cannot be used to purchase a life insurance policy.

- An individual retirement annuity is one of two types of the traditional IRA. It is a retirement account in which contributions are made in the form of premium payments on a Fixed Dollar Annuity or Variable Dollar Annuity or both.

What is a Roth IRA?

The Roth IRA is an individually established plan that allows contributions to be made with after-tax income. Once contributions are made to the account, the money within the account may be used towards different investment options, such as stocks, bonds, and mutual funds and allowed to grow. Any growth within the account and qualified distributions from the account are not taxed, making this IRA option very attractive to those who qualify. However, you will be charged a penalty if you make a non-qualified distribution. Unlike a traditional IRA, you cannot deduct contributions.

The difference between Roth IRAs and traditional IRAs is the tax treatment of deposits and withdrawals. For Roth IRAs, contributions are made with after-tax income and withdrawals are exempt from federal taxes. For traditional IRAs, the opposite is true: contributions are made with pre-tax dollars and withdrawals are taxed as ordinary income. Therefore, it is advantageous to use a Roth IRA if you expect taxes to be higher than present rates when you retire. In addition, you can withdraw principal contributions (but not gains within the plan) without penalties or taxes any time you want.

What is a SEP IRA?

The Simplified Employee Pension (SEP) IRA is a simplified method for employers to contribute up to 25% or $46,000 of employee's compensation to employees' retirement pensions. The SEP IRA is basically a traditional IRA account that is either labeled as a SEP IRA or as a traditional IRA that accepts SEP contributions. Thus, the SEP IRA is subject to the same tax and withdrawal rules as the traditional IRA. However, with a SEP IRA, the contribution limit is much higher. The size of the contributions made to your account depends on the amount your employer would like to contribute to your account.

- You and your employer establish this account, but only your employer contributes to this retirement fund. Funds within the account may be used towards the investment option(s) of your choice.

What is a Simple IRA?

The SIMPLE IRA, Savings Incentive Match Plan for Employees IRA, is a retirement plan that allows the employer to deduct a certain percentage or dollar amount of your salary each period to contribute to a retirement account. One notable aspect of this retirement plan is the ability of the employer to match any contributions that an employee makes to the SIMPLE account. Your employer may match up to $10,500 per year, and for those ages 50 and over, $13,000 per year. The SIMPLE IRA plan is subject to the same withdrawal rules as the traditional IRA: early withdrawals are taxed. Earnings within the account are also taxed.

Variations of the different IRAs

A Spousal IRA is either a traditional or Roth IRA funded by a married taxpayer in the name of his or her spouse who has less than $2,000 in annual compensation. The couple must file a joint tax return in the year of the contribution. The working spouse may contribute up to $2,000 per year to the Spousal IRA and up to $2,000 per year to his or her own IRA. A couple, then, may contribute up to $4,000 per year as long as neither IRA receives more than $2,000.

- A Rollover (Conduit) IRA is a traditional IRA set up by an individual to receive a distribution from a qualified retirement plan. Distributions transferred to a rollover IRA are not subject to any contribution limits. The distribution may also be eligible for transfer into a qualified retirement plan available through a new employer.

- An Inherited IRA is either a traditional or a Roth IRA acquired by the non-spousal beneficiary of a deceased IRA owner. Special rules apply to an inherited IRA. A tax deduction is not allowed for contributions to this IRA, a rollover to or from another IRA owned by the heir is not permitted, and the proceeds must be distributed and taxed within a specific period as established by the Internal Revenue Code.

- An Education IRA (EIRA) is an IRA established to provide funds for a beneficiary to use for higher education purposes. There is no tax deduction allowed for the contribution, but all deposits and earnings may be withdrawn free of tax and penalties if used to pay for the costs of higher education. Beginning in 2002, EIRA proceeds may also be used free of tax and penalty to pay for the qualified expenses of a kindergarten through 12th grade education in public, private, and/or religious schools. EIRA contributions are limited to a maximum of $500 per year, but that's in addition to the $2K limit on any other IRA. Beginning in 2002, allowable EIRA contributions increase to $2,000 per year.