What is an IRA?

What is an IRA? October 11, 2010

Often called Individual Retirement Accounts, IRAs actually stand for Individual Retirement Arrangement.  The IRA is a retirement plan that allows individuals to save for their future.  IRAs can be opened at banks, brokerage firms, and mutual fund companies.  You can open multiple IRAs if you really wanted to but I don’t recommend it because it can be a hassle to keep track of all the accounts.  Regardless of the number of IRAs you open, you must adhere to the contribution limits set by the IRS.  Something else we’ll cover are the different ‘flavors’ of IRAs that provide tremendous benefits to as an investor – Traditional, ROTH, SEP. SIMPLE.  Finally, within most IRAs, you have the flexibility to choose your investments as well.

Let’s talk a little more about the general features of IRAs.

General IRA Rules

1. As long as you have an earned income, you can contribute to an IRA.

The maximum you can contribute to an IRA is the SMALLER of the following:

– $5,000 ($6,000 if you are over 50)

or

–  Your taxable income.

(This just means that if you only make $3,000 in taxable income for the year, you can’t contribute more than $3,000 to an IRA.)

Interesting Fact: If you are married and filing jointly, you and your spouse can both contribute $5,000 to IRA ($6,000 if over 50) – even if your spouse didn’t earn an income.

2. You must wait until 59 ½ to withdraw from your IRA without penalty.

The IRS created the IRA as a tool for your retirement and provides tax benefits that encourage people to save for retirement.  If a person withdraws funds before age

59 ½, they will be subject to a 10% penalty due at their tax time.

Regardless of when you withdraw funds from your IRA, it will be considered as income and you’ll pay taxes on the funds.  (This isn’t the case for ROTH – we’ll explain in another article)  Remember, if you are under 59 ½, you’ll pay both taxes AND the 10% penalty.

3. You can rollover your IRA to another company.

An IRA rollover is simple to do and is a non-taxable, penalty free event.  You can move your IRA from one institution to another in order to take advantage of lower fees, better investment options, or better customer service.  We’ll talk about rollovers in another article, but just know that you have the flexibility to change the company that holds your IRA.

4. At age 70 ½, you MUST start taking withdrawals from your IRA.

This is called the RMD or Required Minimum Distribution.  The exact amount is based on the IRS life expectancy table found here.   The RMD is designed to make you take your money so that it can be taxed.  Sneaky huh.  The RMD does not apply to ROTH IRAs.

Your RMD is calculated based on the total value of all your IRAs.  You can withdraw the RMD from one or multiple IRA accounts, as long as you do so before Dec. 31 of that year (April 15 for the year in which you turn 70 ½).  If you fail to take you RMD, the amount that wasn’t withdrawn is subject to a 50% tax – but this can be waived under certain circumstances.

5. You can inherit an IRA.  Likewise, if you die, your IRA is passed to a beneficiary.

If you pass away and your spouse inherits your IRA, they:

– Can designate the account as their own (they can make contributions to it)

– Can roll it into another IRA they own or another qualified retirement plan they hold.

If you pass away and a non-spousal beneficiary inherits your IRA, they:

– CANNOT treat the account as their own (they CANNOT make contributions to it)

– CANNOT roll money into or out of the inherited IRA

– You CAN move the account to another provider as long as it remains in the name of the deceased IRA owner for the benefit of you as a beneficiary.

Where to open an IRA?

Where you open an IRA will determine what investment options are available to you.  This is an important aspect to consider as IRA providers like banks and credit unions often only provide CDs as an IRA investment.  If you want to invest in mutual funds, individual stocks, bonds, or ETFs, you’re better off researching brokers or mutual fund companies that can provide those options for you.

A few to consider:

Vanguard

T. Rowe Price

Fidelity

Zecco

Scottrade

ETrade

Questions to ask before you open an IRA

What is the minimum investment to open an IRA?

What is the minimum investment to add to my IRA?

Are there annual fees to keep the IRA open?

What investments are available: stocks, bonds, mutual funds, ETFs, CDs?

What fees do these investments have?

Can I manage my account online?  Is there a local office representative I can contact?

Other types of IRAs (IRA Flavors)

1. Traditional IRA – Contributions to Traditional IRAs are pre-tax and are often tax deductible.  Both contributions and earnings are treated as taxable income when you withdraw the funds.  The account is subject to RMD rules.

2. ROTH IRA – Contributions to ROTH IRAs are after-tax and are not tax deductible.  The principal and interest can be withdrawn TAX-FREE after age 59 ½ as long as the initial investment was made 5 years prior from the time of distribution.  (After 5 years of the initial investment, the investor can actually take the principal tax-free and penalty free even if he is under 59 ½. The interest, however, must remain in the account until age 59 ½ to be distributed tax and penalty free.)

(For a more detailed comparison between ROTH and Traditional IRAs, stay tuned to our upcoming article – What’s the difference between ROTH and Traditional)

3. SEP IRA – Contributions to SEP IRAs (Simplified Employee Pension) can be made by an employer – generally a small business or self-employed individual can use this IRA option.  The rules follow that of a Traditional IRA.

4. SIMPLE IRA – The SIMPLE IRA is also a simplified employee pension plan that allows both the employer and employee to contribute to the account – like a 401(k) but with lower contribution limits and less administration.

_______________________________________________________________

I know that we went through a lot of information here, but I feel that it was a needed summary of what an IRA is.  There are a few areas that I want to be sure to cover in detail later, but I think this provides you with the general knowledge of what IRAs are all about.  Opening an IRA is simple and is something you should definitely consider sooner than later.  You’ll be happy you did, especially when it comes closer for you to retire!

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