individual retirement account

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Tax-deferred retirement account allowing an individual to contribute a pre-set amount annually (up to $4,000 in 2006, or $8,000 for a married couple filing jointly) from personal income. The maximum individual contribution will rise to $5,000 in 2008 and afterward will be indexed according to inflation. Individual taxpayers over age 50 are permitted an additional $1,000 a year "catch up" IRA contribution. IRA contributions are tax deductible regardless of income if neither the taxpayer nor their spouse is enrolled in an employer-sponsored pension plan. Individuals covered by a company retirement plan may deduct IRA contributions if adjusted gross income is below $53,000 on a joint return or $33,000 on a single return. Couples with incomes between $53,000 and $63,000 and single taxpayers with incomes between $33,000 and $43,000 are allowed partial deductions. After 2007, the income limit for fully deductible IRA accounts will rise to $50,000 for single taxpayers and $80,000 for married couples. Individuals barred from making deductible contributions may open nondeductible IRA accounts and gain the benefit of tax deferral on earnings.

Withdrawals from an IRA before age 591⁄2 are generally subject to a 10% penalty tax, although certain types of withdrawals are exempted. Individuals may contribute annually to an IRA account until age 701⁄2. After reaching that age, individuals must begin withdrawing funds according to an IRS schedule based on life expectancy. IRA accounts may be invested in many different types of investments, including stocks, bonds, certificates of deposit, and mutual funds.

See also 401(K) Plan; Individual Retirement Account Rollover; Keogh Plan; Roth Ira; Self-Directed Ira.

An individual retirement account (IRA) is a tax-deferred retirement program in which any employed person can participate, including self-employed persons and small business owners. In most cases, the money placed in an IRA is deducted from the worker's income before taxes and is allowed to grow tax-deferred until the worker retires. IRA funds can be invested in a variety of ways, including stocks and bonds, money market accounts, treasury bills, mutual funds, and certificates of deposit. Intended to make it easier for individuals to save money for their own retirement, IRAs are nonetheless subject to a number of complex government regulations and restrictions. The extent of annual contributions, and the tax deductibility thereof, are dependent on the individual worker's situation.

The main difference between IRAs and employer-sponsored retirement plans is that IRA funds—although held by a trust or annuity—are under the complete discretion of the account holder as far as withdrawals and choice of investments. For this reason, IRAs are known as self-sponsored and self-directed retirement accounts. Even combination plans that allow employers to make contributions, like Simplified Employee Pension (SEP) IRAs, are considered self-sponsored since they require the employee to set up his or her own IRA account. A special provision of IRAs allows individuals to roll over funds from an employer-sponsored retirement plan to an IRA without penalty.

IRAs were authorized by Congress in 1974 as part of a broader effort to reform laws governing pensions. Recognizing that employers facing intense competition might decide to cut costs by reducing the retirement benefits provided to employees—and that government programs such as Social Security would not be enough to fill in the gaps—Congress sought to encourage individual taxpayers to undertake long-term savings programs for their own retirement. The Internal Revenue Service responded by making provisions for individual retirement accounts in section 408 of the tax code. IRAs quickly became recognized as one of the most opportunistic and flexible retirement options available, enabling workers to control their own preparations for the conclusion of their working lives.

Ira Provisions

In the original provisions, elective pre-tax contributions to IRAs were limited to $1,500 per year. The maximum annual contribution increased to $2,000 in 1982, but new restrictions were imposed upon workers who were covered under an employer's retirement plan. For example, such workers were not eligible to deduct their total IRA contributions unless their adjusted gross income was less than $25,000 if unmarried, or less than $40,000 if married. A partial deduction was available for single workers who earned up to $35,000 and married workers who earned up to $50,000, but no deductions were allowed for people with higher income levels. These restrictions did not apply to self-employed individuals and others who did not participate in an employer's plan. In 1998, the income limits for people covered under an employer's retirement plan were increased to $30,000 for unmarried workers and $50,000 for couples.

The way the tax code was written, individuals were intended to begin making regular withdrawals from their IRAs upon retirement. These withdrawals would be considered income and subjected to income tax, but the individual was presumed to be in a lower tax bracket by this time than they had been during their working years. "Ordinary" distributions from an IRA are those taken when a worker is between the ages of 59½ and 70½. Though workers are not required to begin receiving distributions until they reach age 70½, most establish a regular schedule of distributions to supplement their income during this time. The total annual distributions cannot exceed $150,000 per year, or they are subject to a 15 percent penalty in addition to the regular income tax. "Early" withdrawals, or those taken before a worker reaches age 59½, are subject to a 10 percent penalty on top of the regular income tax, except in cases of death or disability of the account holder. This penalty is intended to discourage younger people from viewing an IRA as a tax-deferred savings account. "Late" withdrawals, or those beginning after a worker reaches age 70½, are subject to a whopping 50 percent penalty. Since IRAs are supposed to provide income for the worker during retirement rather than inheritance for others after the worker's death, the government imposed an especially stiff penalty to ensure timely distributions.

Subsequent legislation—in particular, the Tax Reform Act of 1986—has refined the scope, provisions, and requirements of IRAs so that other forms are available besides the basic, individual "contributory" IRA. As outlined by W. Kent Moore in The Guide to Tax-Saving Investing, the different IRA variations include: 1) spousal IRAs, which enable a working spouse to contribute to an IRA opened for a nonworking partner; 2) third-party-sponsored IRAs, which are used by employee organizations, labor unions, and others wishing to contribute on workers' behalf; 3) Simplified Employee Pensions (SEPs), which enable employers to provide retirement benefits by contributing to workers' IRAs; 4) Savings Incentive Match Plan for Employees (SIMPLE) IRAs, which require employers to match up to 3 percent of an employee's salary, or $6,000 annually, plus allow employees to contribute another $6,000 per year to their own accounts; 5) rollover contribution accounts, which allow distributions from an IRA or an employer's qualified retirement plan to be reinvested in another IRA without penalty; and 6) Roth IRAs, which enable single people with an annual income of less than $95,000 and married couples with an annual income of less than $150,000 to make a nondeductible contribution of $2,000 per year, whether they are covered by an employer's plan or not. It is also possible for those earning less than $100,000 per year to convert a regular IRA to a Roth IRA by paying any deferred income tax. Though money placed in Roth IRAs is subject to taxes when invested, the earnings grow tax-deferred and the withdrawals are tax-free after five years.

Factors to Consider

Those interested in opening an IRA should familiarize themselves with the current regulations governing the amounts that may be contributed, the timing of contributions, the criteria for tax deductibility, and the penalties for making early withdrawals. They should also shop around when investigating financial institutions that offer IRAs—such as banks, credit unions, mutual funds, brokerage firms, and insurance companies—inasmuch as fees vary from institution to institution, ranging from no charge to a one-time fee for opening the account to an annual fee for maintaining the IRA. Financial institutions also differ in the amount of minimum investment, how often interest is compounded, and the type and frequency of account statement provided. There is no limit to the number of IRAs an individual can open, as long as he or she does not exceed the maximum allowable annual contribution.

Another important factor to consider, in addition to the trustee of the account, is where the IRA funds should be invested. Individuals have a wide range of investment options available to choose from—including bank accounts, certificates of deposit, stocks, bonds, annuities, mutual funds, or a combination thereof—each offering different levels of risk and rates of growth. According to the Entrepreneur Magazine Small Business Advisor, the ideal IRA investment is one that is reasonably stable, can be held for the long term, and provides a level of comfort for the individual investor. Most financial advisors advise against playing the stock market or investing in a single security with funds that have been earmarked for retirement, due to the risk involved. Instead, they recommend that individuals take a more diversified approach with their IRAs, such as investing in a growth-income mutual fund, in order to protect themselves against inflation and the inevitable swings of the stock market.

The decision about where IRA funds should be invested can be changed at any time, as often as the individual deems necessary. Switching to a different type of investment or to a mutual fund with a different objective usually only requires filling out a transfer form from the sponsoring financial institution. Since the IRA simply changes custodians in this type of transaction, and never passes through the hands of the individual investor, it is not subject to any sort of penalty or tax, and it is not considered a rollover.

Despite the number of decisions involved, IRAs nonetheless provide an important means for people to save for their retirement. "The advantages of IRAs far outweigh the disadvantages," as Moore noted. "Earnings for either deductible or nondeductible IRAs grow faster than ordinary savings accounts, because IRA earnings are tax deferred, allowing all earnings to be reinvested. Even when withdrawals are made, the remaining funds continue to grow as tax-deferred assets."

Further Reading:

Blakely, Stephen. "Pension Power." Nation's Business. July 1997.

Crouch, Holmes F. Decisions When Retiring. Allyear Tax Guides, 1995.

The Entrepreneur Magazine Small Business Advisor. Wiley, 1995.

Korn, Donald Jay. "Tax-Deferred Vehicles That Will Last a Lifetime." Black Enterprise. October 2000.

Moore, W. Kent. "Deferring Taxes with Retirement Accounts." In The Guide to Tax-Saving Investing, by David L. Scott. Globe Pequot Press, 1995.

Wiener, Leonard. "How to Keep One Step Ahead: Hot Tips for Turning an Annual Chore into Many Happy Returns." U.S. News and World Report. March 9, 1998.

Wiener, Leonard. "How to Unscramble a Nest Egg." U.S. News and World Report. July 5, 1999.

See also: Retirement Planning

Individual Retirement Account, or IRA, was created in 1974 for those individuals not covered by company pensions. Initially individuals could make tax-deductible contributions of up to $1,500 per annum to an IRA account, but in 1981, a new tax law allowed individuals to make tax-deductible contributions up to $2,000 per annum; the sum was raised to $3,000 for tax year 2002. The Taxpayer Relief Act of 1997 gave employees already in corporate pension programs the ability to contribute monies to their own IRA accounts. IRA contributions can be placed in high-yield investments, with taxation deferred until the money is withdrawn. In most cases, IRA contributions cannot be withdrawn without penalty until after age fifty-nine and a half. Congress did make some exceptions to the rule, however, for qualified education expenses through the creation of an Education IRA and for first-time home purchases. The Taxpayer Relief Act also created the Roth IRA, in which the earnings are tax-free, but there are no tax-deduction benefits for the contributions made each year. Contributions to a Roth IRA are made with after-tax rather than pre-tax dollars, but earnings are tax-free. If certain conditions are met, the earnings are free of Internal Revenue Service penalties. Unlike a traditional IRA, Roth contributions are allowed beyond age seventy and a half.

Bibliography

Bamford, Janet, et al. The Consumer Reports Money Book: How to Get It, Save It, and Spend It Wisely. Yonkers, N.Y.: Consumer Reports, 2000.

Downing, Neil. The New IRAs and How to Make Them Work for You. Chicago: Dearborn Trade, 2002.

A means by which an individual can receive certain federal tax advantages while investing for retirement.

The federal government has several reasons for encouraging individuals to save money for their retirement. For one, the average life span of a U.S. citizen continues to increase. Assuming the average age of retirement does not change, workers who retire face more years of retirement and more years to live without a wage or salary.

Uncertainty over the future of the federal Social Security system is another reason. U.S. workers generally contribute deductions from their paychecks to the Social Security fund. In theory, this money comes back to them, usually upon their retirement. But a substantial number of politicians, economists, and scholars contend that the Social Security fund is being drained faster than it is being filled, and will go broke in a number of years, leaving retirees to survive without government assistance.

Regardless of its future, many people consider the retirement benefits of Social Security to be inadequate, and look for other methods of funding their retirement years. Many employers offer retirement plans. These plans vary in form, but generally offer an employee retirement funds that grow with continued employment. Yet this benefit is not always available to workers. A changing economy has caused some employers to cut back retirement plans or cut them out completely. Often, part-time, new, or temporary workers do not qualify for an employer's retirement plan. And individuals who are self-employed cannot choose this job benefit.

To help people prepare for their retirement, Congress in 1974 established individual retirement accounts (IRAs) ( Employee Retirement Income Security Act [ERISA] [codified in scattered sections of 5, 18, 26, and 29 U.S.C.A.]). These accounts may take a variety of forms, such as savings accounts at a bank, certificates of deposit, or mutual funds of stocks. Initially, IRAs were available only to people who were not participating in an employer-provided retirement plan. This changed in 1981, when Congress expanded the IRA provisions to include anyone, regardless of participation in an employer's retirement plan (Economic Recovery Tax Act [ERTA] [codified in scattered sections of 26, 42, and 45 U.S.C.A.]). The goal of ERTA was to promote an increased level of personal retirement savings through uniform discretionary savings arrangements.

A movement to bolster the federal budget by eliminating many existing tax shelters prompted portions of the Tax Reform Act of 1986 (codified in scattered sections of 19, 25, 26, 28, 29, 42, 46, and 49 U.S.C.A.) and another change in IRA laws. This time, Congress limited some of the IRA's tax advantages, making them unavailable to workers who participate in an employer's retirement plan or whose earnings meet or exceed a certain threshold. Yet, other tax advantages remain, and the laws still allow anyone to contribute to an IRA, making it a popular investment tool.

It is difficult to understand the advantages an IRA offers without understanding a few basics about federal income tax law. Generally, a person calculating the amount of tax she or he owes to the government first determines the amount of income received in the year. This is normally employment income. Tax laws allow the individual to deduct from this figure amounts paid for certain items, such as charitable contributions or interest on a mortgage. Some taxpayers choose to take a single standard deduction rather than numerous itemized deductions. In either case the taxpayer subtracts any allowable deductions from yearly income, and then calculates the tax owed on the remainder.

Taking deductions is only one of the ways a taxpayer can reduce taxes by investing in an IRA. Under current laws, those who do not participate in a retirement plan through work or who earn less than $25,000 a year may receive the greatest tax advantages by contributing to an IRA.

Various plans may constitute employer-maintained retirement plans, such as standard pension plans, profit sharing or stock bonus plans, annuities, and government retirement plans. Someone who does not participate in such a plan — whether by choice or not — is entitled to contribute to an IRA up to $2,000 a year or 100 percent of her or his annual income, whichever is less. The amount contributed during the taxable year may then be taken as a deduction. Married couples may contribute $4,000 to IRAs each year and deduct the full $4,000, if neither spouse participates in an employer-provided retirement plan.

A married taxpayer who files a joint tax return with a spouse who does not work may deduct contributions toward what is called a spousal IRA, or an IRA established for the spouse's benefit. If neither spouse is a participant in an employer-provided retirement plan, up to $4,000 may be deductible.

An individual who participates in an employer's retirement plan may still be entitled to all the tax benefits of an IRA. If a person filing an individual tax return makes less than $25,000 a year, that person may contribute to an IRA and take a full deduction for the amount contributed during the tax year. A taxpayer filing an individual tax return who makes between $25,000 and $35,000 a year may take a partial deduction, the amount of which decreases as income increases. The same rules apply for married taxpayers filing a joint tax return with an income of less than $40,000 in the former instance and between $40,000 and $50,000 in the latter.

Taxpayers who contribute to IRAs usually realize tax benefits even when the law does not permit them to take deductions. That is because income earned on IRA contributions is not taxed until the funds are distributed, which usually occurs at retirement. Income that is allowed to grow, untaxed, for several years, grows faster than income that is taxed each year.

To avoid abuses and excessive tax shelters, Congress has placed limits on the extent to which IRAs can be used as a financial tool. Individuals with IRAs are permitted to make contributions of no more than $2,000 a year, and contributions exceeding that amount are subject to strict financial penalties by the Internal Revenue Service each year until the excess is corrected. The owner of an IRA generally may not withdraw funds from that account until age 59½. Premature distributions are subject to a 10 percent penalty in addition to regular income tax. Taxpayers may be able to avoid this premature distribution penalty by "rolling over," or transferring, the distribution amount to another IRA within sixty days.

An individual may elect not to withdraw IRA funds at age 59½. However, the law requires IRA owners to withdraw IRA money at age 70½, either in a lump sum or in periodic (at least annual) payments based on a life expectancy calculation. Failure to comply with this rule can result in a 50 percent penalty on the amount of the required minimum distribution. Contributions to an IRA must stop at age 70½.

A retirement plan. The “traditional” IRA allows individuals to contribute pretax earnings up to a maximum yearly allowance and to defer income taxes until the money is withdrawn after retirement. The “Roth” IRA allows individuals to contribute aftertax earnings and pay no taxes on future withdrawals. In contrast to a 401(k) plan, an IRA is funded entirely by the individual tax payer.

An investing tool used by individuals to earn and earmark funds for retirement savings. There are several types of IRAs: Traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs.

Traditional and Roth IRAs are established by individual taxpayers, who are allowed to contribute 100% of compensation (self-employment income for sole proprietors and partners) up to a set maximum dollar amount. Contributions to the Traditional IRA may be tax deductible depending on the taxpayer's income, tax filing status and coverage by an employer-sponsored retirement plan. Roth IRA contributions are not tax-deductible.

SEPs and SIMPLEs are retirement plans established by employers. Individual participant contributions are made to SEP IRAs and SIMPLE IRAs.

Also referred to as "individual retirement arrangements."

Investopedia Says:
With the exception of Roth IRAs, where eligible distributions are tax-free, eventual withdrawal from an IRA is taxed as income; including the capital gains. Because income is likely to be lower after retirement, the tax rate may be lower. Combined with potential tax savings at the time of contribution, IRAs can prove to be very valuable tax management tools for individuals. Also, depending on income, an individual may be able to fit into a lower tax bracket with tax-deductible contributions during his or her working years while still enjoying a low tax bracket during retirement.

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A savings certificate exempt from income tax until the time of withdrawal. There are limits to the amount that can be saved annually under this plan, and there are conditions of withdrawal for maximal interest and tax advantage.

• Income Tax - individual retirement account: IRA; tax-free savings account into which annual contributions are made that allows deferment of tax payments until retirement