Individual Retirement Accounts provide investors with a way to invest for retirement with tax advantages. They are retirement plans for individuals rather than groups of employees. Many rules and regulations are similar to those that govern work retirement plans like 401(k)s. However, IRA contribution limits are far lower than work retirement plan limits, and they phase out for people with a high modified adjusted gross income.
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Traditional IRA contributions are tax deductible for many people – those in high income brackets might not be eligible to take the deduction. Investments grow tax-deferred, meaning that investments are not subject to capital gains taxes. Then distributions are subject to standard income taxes. Unlike traditional IRAs, Roth IRA contributions are made on an after-tax basis and are not tax deductible. But once an individual makes a Roth contribution, that money will not be taxed again upon distribution during retirement. Roth investments also grow tax-deferred.
Compared with a work retirement plan, the advantage to an IRA is the ability to select an investment platform and have access to virtually any security investment. On the other hand, IRAs require more legwork to establish (individuals can start IRAs through banks, mutual fund providers or brokerage houses) and have some income limitations. And, unless your IRA is through your small-business employer, matching contributions and payroll deductions are not available. Without payroll deductions you’ll need to remember to make contributions.
Contribution/deduction limits are combined for traditional and Roth IRAs – so you don’t get to double dip. For example, someone allowed to contribute $5,000 to an IRA could contribute $3,000 to a traditional IRA and $2,000 to a Roth IRA. The income restrictions are higher for Roth IRAs – so someone might make too much money to be eligible to contribute to a traditional IRA, but that individual might still be able to contribute to a Roth IRA.
For more information about deduction limits, contribution limits and income phase-outs, see these graphs:
Many people who invest in an IRA also participate in a work retirement plan. For people who have maxed out work retirement plan contributions but want to save additional money each year for retirement, IRAs are an excellent way to continue to gain tax benefits similar to a work retirement plan. As previously mentioned, there are income limitations that could preclude some people from deducting IRA contributions.
IRA distributions taken prior to the calendar year that the owner turns 59½ are subject to a 10% penalty in addition to standard income taxes. Just like most work retirement plans, IRA owners are legally required to take IRA distributions by the April of the calendar year following the calendar year that the owner reached age 70½. This is called a Required Minimum Distribution.