IRAs: Individual Retirement Arrangements

An Individual Retirement Arrangement (IRA) is one of the best ways to save for retirement while deferring taxes and compounding interest over the years.

Traditional IRAs have many of the same advantages as Roth IRAs and some key distinctions all of which will help investors decide which type of retirement account is the right choice for them.

IRAs are for long-term investment horizons

For the most part an IRA should be used as a long range savings plan. Tying up funds in an IRA can be costly if savers decided to withdraw funds before age 59 ½. There are penalties and taxes will be due at the taxpayer’s current taxable rate because withdrawal will be considered taxable income in the year it is taken.

IRA are tax deferred plans - withdrawals are considered taxable income

IRAs are generally funded with pre-tax dollars and taxes on the investment and earnings are deferred until withdrawal. This is different from the Roth IRA, where the account is funded with after-tax dollars and is never taxed further if used for qualified purposes. Even the earnings on a Roth IRA can be completely exempt from taxation. For both the traditional IRA and Roth IRA anyone with taxable compensation from wages, bonuses, self-employment income, alimony or separation maintenance, can open an IRA account up to the maximum annual contribution level. Non-working spouses are also eligible for IRAs up to $4,000 per tax year beginning in 2005 and gradually adjusting for inflation.

Everything you need to know about IRAs

A quick review of the major IRA guidelines and decisions you will need to make to maximize this powerful tax-deferred retirement plan.

IRAs have mandatory withdrawal rules

Another difference between a traditional IRA and a Roth IRA is that with traditional IRAs the retiree must make mandatory withdrawals by April 1st the year after the year in which they reach the age of 70 ½. If the minimum amount is not withdrawn, the remaining amount is taxed an excise tax at a rate of 50%, incentive enough for most IRA account holders to be sure to withdraw the funds on time each year. There are no such minimum withdrawal requirements on a Roth IRA.
 

IRAs have maximum contribution limits

As with the Roth IRA, the traditional IRA has limits as to how much can be deposited into the account each year. The amount increases annually and is adjusted by $500 to $1000 per year (depending on the year) for older individuals so that they can have the opportunity to catch up on their savings for retirement. The amount that can be contributed also depends on Adjusted Gross Income (AGI), with separate amounts for single taxpayers and those who are married filing their taxes jointly.

Early withdrawal penalties apply

There are circumstances where funds from either a traditional IRA or Roth IRA can be withdrawn early without being penalized. These include certain expenses related to education, the disability or medical expenses of an investor, or in the case of their death, the beneficiary can receive the funds without penalty.

What type of IRA to chose?

To determine which type of IRA is really the best choice an investor should consider their income, whether or not they will need the money before age 70 ½, or if they would rather keep the account funded beyond that age. Also a consideration is whether the tax savings helps with their financial goals at a younger age or if they will be better off funding an IRA with after tax dollars.