Individual Retirement Account (IRA)
The reasoning behind creating the individual retirement account (IRA) was to offer individuals and married couples a tax-advantaged way to put money away for retirement if they did not have access to a pension plan through work. The legislation that created these sheltered vehicles for taxpayers was developed in response to a trend among employers. More and more companies began limiting or eliminating pension plans that were costing them too much money, leaving workers exposed to tough times in their retirement years. It was recognized that government programs such as social security would not be sufficient to take care of all needs for retirees, and that retirees needed to have a hand in creating a sustainable life for themselves.
With an IRA, you can put part of your earnings, sometimes before they are taxed, into an account that will grow over the course of your work years, providing you with a lump of money to draw upon when you retire. Once you begin to withdraw funds, and their earnings, they become taxable. The thinking is that you will be in a lower tax bracket when you retire and will pay fewer taxes on the same dollars earned earlier.
An IRA is not itself an investment. It is a custodial account, which must be maintained by an institution approved by the IRS, on your behalf. You have investment decision-making power. Funds in an IRA are held for you to draw upon within certain rules, or for any beneficiaries you name in the event of your death.
What Is Considered Earned Income
The key to being able to take advantage of an IRA is that you must have earned at least the amount you will be contributing to one of these accounts. There are maximum income thresholds shown in tables herein. The sources of earned income that qualify are:
Wages
Salary
Tips
Professional fess
Bonuses
Here is an example of how the tax savings would work:
IRA dollars saved over 30 years |
$90,000 |
Working years tax bracket 33% |
$29,700 |
Retirement tax bracket 15% |
$13,500 |
Tax savings |
$16,200 |
At the same time that you are pushing off your tax obligation on the dollars you are saving through your IRA, you are lowering your current income, and possibly reducing your tax responsibility a bit there, too.
Contributions to an individual retirement account must be made from earned income. Your contribution will fall below the allowable limit if you do not earn at least that amount. For example, if you earn $2,400 one year you can put all of it in your IRA, but you cannot contribute the maximum of $4,000 for that year.
If you have access to a company plan, you may be able to participate in it while also being entitled to fund an IRA. As you progress through your working years, you may have periods when you are working for an employer who can offer you a company plan and periods when you are not. Over time you may accumulate various retirement accounts of which IRAs will be a part. You would need to talk to a tax professional to see how your individual situation would benefit from opportunities to shelter money from taxes.
What You Can Put in Your IRA
Contributions to an IRA can only be made in cash. Except in some cases of rolling over an account, you are prohibited from contributing property such as stocks or bonds. Some other restrictions for IRAs include:
Cannot use an IRA as collateral for a loan
Cannot borrow from an IRA
Cannot sell property to it, or buy property from an IRA
Cannot use funds that have not been distributed to you to buy property for your personal use
Investing in collectibles is restricted only to certain coins
How Much Money You Can Put in Your IRA
The maximum contribution levels for IRAs have been established through 2009. After 2009 the plan will be to have contributions indexed to inflation costs, and will increase in increments of $500. The good news is that overall the limits are increasing, and people over fifty can even contribute more. The following table spells it out.
Tax Year |
Maximum Contribution |
Bonus Contribution over Age 50/Total |
2005 |
$4,000 |
$500/$4,500 |
2006 |
$4,000 |
$1,000/$5,000 |
2007 |
$4,000 |
$1,000/$5,000 |
2008 |
$5,000 |
$1,000/$6,000 |
2009 |
$5,000 |
$1,000/$6,000 |
Some Fine Points
As with most things related to the government, not everything is simple with an IRA. There are some rules and restrictions regarding use of an IRA that are best answered by a tax or investment professional. Nevertheless, here are a few of the rules you need to know:
You can contribute to an IRA every year you earn income until age 70½.
At age 70½ you must begin to withdraw money and begin paying taxes.
Your income must equal at least the amount you will be contributing to your IRA.
There is no limit to how large your IRA can grow.
You do not need to contribute the same amount each year.
You can invest in multiple IRAs, but overall contribution is capped annually.
You can begin to withdraw money without a 10% penalty when you reach age 59½.
Funding your IRA can be done either with a lump sum once a year or by spreading smaller installments over the course of a year. It is possible to declare an IRA deduction for a tax year but defer making the actual contribution of funds until April 15 of the following year (when you would be filing taxes for the prior year). You need to be sure the institution holding your account is clear for which year your contribution should be credited. For example, if you want to have a deposit made to your IRA for the tax year 2006 but the funds are not transferred until March of 2007, you need to be sure your investment firm knows those monies are earmarked for 2006 and not 2007.
Married Tax Filers
Married people can put aside and deduct up to $8,000 a year, if both are working and not using any company-sponsored pension plans. It is possible for one spouse to use a company plan and the other to use an IRA. All is not lost, however, as you can get a partial tax break on your IRA contribution even if you use company-sponsored retirement savings. In 2005 the income threshold to receive a partial break in this instance was $60,000 for an individual and $80,000 for married filers. If only one of you has a company plan, a combined income of $160,000 would still protect some IRA deductions.
When you withdraw from your IRA, you will be obliged to pay taxes on your contributions, which were tax-deferred, as well as the earnings of your investment. If you withdraw before age 59½, you will incur penalties on top of the tax obligations.
Following is a chart prepared by the mutual fund firm Vanguard showing income levels for you or you and a spouse, filing jointly, to be eligible to deduct your IRA contribution either fully or partially.
Tax Year |
Married Filing Jointly |
Single Filer/Married Filing Separately |
Full Deduction/Partial |
Full Deduction/Partial |
|
2006 |
Under $75,000/$75,000–85,000 |
Below $50,000/$50,000–60,000 |
2007 |
Under $80,000/$80,000–100,000 |
Below $50,000/$50,000–60,000 |
2008 |
Under $80,000/$80,000–100,000 |
Below $50,000/$50,000–60,000 |
Many people wonder if they and their spouse can hold a joint IRA. The answer is no, they cannot. These accounts are designed to be “individual” retirement accounts. Monies in each person's name cannot be commingled.
If you are working and your spouse is not, it is possible to set up a traditional IRA for you and a special spousal account for your spouse. Here again, you need the advice of a professional to evaluate your particular circumstances.
