Individual Retirement Accounts

Learn how an IRA can be a valuable component of your retirement strategy.

Individual Retirement Accounts, or IRAs, are an important element of many retirement plans. For a variety of reasons, IRAs are an excellent part of your personal financial investments. Even if you have a pension or contribute to a 401(k) plan, you may still want to consider an IRA as a supplement to them.

Advantages of IRAs

• Contributions to and earnings from IRAs are tax deferred. You don't pay taxes on the funds in an IRA until you decide to use them.

• In certain situations, IRA contributions are tax deductible. The rules change, so check with the Internal Revenue Service (IRS) to determine if and what you can deduct.

• You choose the investment allocation for your IRA (e.g., mutual funds, stocks, bonds, certificates of deposit).

• You choose the amount of money you want to invest, up to a maximum of $4,000 per year ($5,000 per year if you have reached age 50). If you and your spouse file a joint tax return, you can each contribute to separate IRAs with a total contribution limit of $8,000 to $10,000. Starting in 2008, the maximum contribution rises to $5,000 per year ($6,000 after age 50). Thereafter, contribution limits will be adjusted for inflation.

• Unlike 401(k) plans and other investment arrangements that require periodic payments, you can choose to stop contributing to the IRA account at any time.

Disadvantages of IRAs

• If you decide to access your money before retirement, you may have to pay stiff penalties.

• If you are a high-wage earner, you may not be able to deduct your contributions on your taxes.

• You may have to invest more time in record keeping and filing tax forms when you start accessing your funds.

• You are limited by the IRS to contributing a maximum of $4,000 ($5,000 if you have reached age 50) per taxpayer per year. In 2008 the annual limit rises to $5,000 ($6,000 after age 50) with cost of living adjustments for subsequent years. See IRS Publication 590: Individual Retirement Arrangements.

How To Create an IRA

You can open an IRA in most banks or with a brokerage firm. If you are eligible to deduct your contribution on your taxes, you can open it as late as the April 15 tax deadline and still take the deduction on your tax form for the previous year. You are eligible to make regular contributions to your IRA, up to $5,000 annually, until you are age 70½.

Investing Your IRA

As with any investment vehicle, you can choose whether to invest for growth, income, or steady fixed-income returns. Your IRA provider will help you understand the funds in which you can invest. You may wish to consult with a financial professional to ensure that your investment choices match well with your current age, risk tolerance, and financial condition.

Accessing Your IRA Funds

According to the IRS, you may begin to withdraw funds from your traditional IRA as soon as you are 59½. Early withdrawals prior to age 59½ result in a 10% penalty. (A tax loophole, known as the 72(t) exception, allows untaxed early withdrawals if they are taken as a series of equal payments over several years. See the IRS article Retirement Plans FAQs regarding Revenue Ruling 2002-62). In certain cases, including paying for higher education, a first-time home, or some medical expenses, you can withdraw IRA funds before age 59½ without paying penalty taxes. For a detailed explanation of the exceptions, see the American Institute of Certified Public Accountants (AICPA) article Withdraw Without Penalty.

Your distribution options with a traditional IRA* generally include the following:

• Receive a lump-sum distribution. If you choose this option, you'll want to be very careful to reinvest your retirement funds cautiously. Remember, your money will be fully taxable as soon as you receive it. If you don't need it all right away, you may be better off withdrawing funds as needed to avoid having to pay a large tax liability.

• You can use your IRA proceeds to buy an annuity that pays you a monthly amount for the rest of your life. You can choose to purchase a "joint and survivor" annuity that includes provisions for paying an annuity to your spouse if he or she survives you. If you buy an annuity, choose carefully. Some annuity schemes are a very bad choice, which will rob you of your hard-earned savings. See the AnnuityLibrary.com article Avoid Variable Annuity Fraud.

For a discussion about taking your IRA funds as a lump sum or an annuity, see the article Take the Money and Run? For more information about IRAs, readUnderstanding IRAs.

* If you have created a Roth IRA, read on because there are special rules for this type of IRA.

The Roth IRA

The Roth IRA, created by the Taxpayer Relief Act of 1997, has several unique features. Here are some of the benefits that you won't find with a traditional IRA.

• Annual contributions (but not the earnings on those contributions) can be withdrawn without tax or penalty at any time.

• You can withdraw the entire balance, including interest earnings, completely tax-free after you reach age 59½. (To have tax-free withdrawal of earnings, your Roth IRA must have been open for at least five years.)

• If you withdraw your funds before age 59½, you will pay penalties (10% and income tax) only on the earned interest, not the original contribution, of a Roth IRA. (Roth IRAs also have the same exceptions to penalties for early withdrawal that are listed above in the section about accessing IRA funds).

• You can continue to make contributions after you reach age 70½ and are not obligated to withdraw funds, ever. This means you can pass this asset to your heirs or beneficiaries tax-free.

• The Pension Protection Act of 2006 allows a direct rollover of 401(k) funds into a Roth IRA. Previously you had to first transfer the 401(k) money into a traditional IRA, and then convert the traditional IRA to a Roth IRA. You might wish to transfer 401(k) funds to a Roth IRA if you leave a job with 401(k) savings and either your new job does not offer a 401(k) plan or you are no longer employed (early retirement, layoff, starting your own business).

There are some restrictions on Roth IRAs, however.

• High-wage earners may be limited or restricted from investing in a Roth IRA. Your adjusted gross income must be less than $110,000 if you file a single tax return, or less than $160,000 if you are a married couple filing a joint tax return.

Check with your financial professional to determine if a Roth IRA is a good investment choice for you. See the Wikipedia: Roth IRA article for an explanation of the differences between traditional and Roth IRAs. Try this Roth IRA calculator to compare taxable savings with the earnings from a Roth IRA.

To learn more about planning for retirement, read the related articles in our Knowledge Center Library.

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