Individual Retirement Accounts (IRA): A Quick Overview

Nowadays, majority of the companies offer a retirement plan and the most common type is the 401(k).

However, if your employer does not offer one, you can still save for retirement and enjoy the tax-deferment features by opening an Individual Retirement Arrangement or IRA.

In the past, not many employer offer a retirement plan at work so the IRA has been a viable option by many as a supplement for the social security retirement. Many financial experts are warning people that you cannot rely on social security anymore as your main source of retirement income because by year 2037, the funds will be depleted unless the government takes drastic action.

In order for you to contribute to an IRA, you must have earned compensation such as wages, salaries, commissions, alimony, self-employment and non-taxable combat pay.  However, if your compensation is less than the maximum contribution amount, your contribution will be limited to the amount of your compensation.

An exception to the rule is for married couples with only one spouse working. If you are the non-working spouse, you can still contribute into an IRA even if you do not have earned compensation for as long as your spouse works and makes more than the maximum amount AND you and your spouse filed taxes jointly.

Types of Non-Employer Sponsored IRA

There are two types of non-employer sponsored IRA: a traditional IRA and a Roth IRA. You can open both and contribute to both in the same year if you wish. However, there is a limit on how much you can contribute.

The maximum IRA contribution is $5,000 ($6,000 for age 55 or older for catch-up) and these applies as aggregate total for both IRA in the same tax year. This means that if you contribute to both traditional and Roth in the same tax year, you cannot put $5,000 in traditional and another $5,000 in Roth, it should be $5,000 in total if you have both IRAs.

Traditional IRAs:

Before 1998, there has been only one form of non-employer IRA in existence so when you say IRA, you pretty much know what it is referring to. Because of the emergence of the Roth IRA, the first type of IRA has been referred to as regular IRA or traditional IRA.

The two key advantages of the traditional IRA are the contribution may be tax deductible and the earnings are tax deferred until you made a distribution on your retirement. However, employees who are covered by a retirement plans at work (even if they do not contribute or participate) are limited in their ability to make tax-deductible contribution to their IRAs.

Usually, a traditional IRA is no longer deductible once you are covered by a retirement plan at work but if you meet the income requirement, you may have a full or partial deduction on the contribution. If  you make $56,000 or less ($89,000 or less for married joint filers), you claim a full deduction from your regular income. However, your deduction is phased-out if you make between $56,000 and $66,000 (between $89,000 and $109,000 for married joint filers) and if you make more than $66,000 ($109,000 for married joint filers), your traditional IRA is no longer deductible.

Traditional IRA can be deducted from your income even if you do not itemize. This is considered as above-the-line deduction.

Once you hit the age of 70 1/2 years, you must make a mandatory minimum distribution from your IRA as otherwise the IRS will start taxing you. Of course, you’ve benefited already for a long time so the IRS wants their money now.

Other Traditional IRA Facts:

Roth IRAs:

Roth IRA was created on January 1, 1998, as a result of Taxpayer Relief Act of 1997. It is named after former Senator William V. Roth, Jr. A Roth IRA is similar to a traditional IRA except that the original contribution is not tax deductible. However, one key advantage of the Roth IRA is that the investment earnings are not taxed when your money is withdrawn at the right retirement age.

A Roth IRA is advisable if you already have a retirement plan at work and you no longer qualify to make a tax deductible traditional IRA. In addition,  a Roth IRA is also perfect if you expect to have a huge retirement income from your employer sponsored retirement plan such as a 401(k) , 403(b) or pension plans as this will put you in a higher tax bracket and may potentially pay higher taxes come retirement time.

There are some income limits for Roth IRA contribution. You can make a full contribution if your gross income is $105,000 or less ($167,000 for married joint filers) in 2010 and is phased out if you make between $105,000 and $120,000 (between $167,000 and $177,000 for married joint filers). However, you can no longer contribute to your Roth IRA if your adjusted gross income is $120,000 ($177,000 for married joint filers).

Additional Roth IRA Facts:

Source: IRS Publication 590

Comments

  1. I like the Roth the best!

    Mainly because you can pull out your contributions at any time, penalty free!

    • alex says:

      That is a really good point. I do like the flexibility that option offers. It is really hard to choose the right retirement option.