An Individual Retirement Account, or IRA, is a excellent way for Americans to save money for retirement tax free. You can open an IRA account even if you already have a 401(k) at your place of employment; if you have leftover money after maxing out on your 401(k), an IRA is a great way to continue generating tax savings.
There are two varieties of IRAs: a regular IRA and a Roth IRA. With a regular IRA, you can make annual contributions and deduct the contributions from your gross income when you prepare your taxes. In this way, your contributions are tax deductible. Your IRA investment will then grow over the years, generating dividend and capital gains income, depending on how you have the IRA invested. As long as you keep the money in the account, these gains are also tax free; if you continue to make contributions on an annual basis, you can grow a substantial nest egg over the years.
It is only when you begin making withdrawals from a regular IRA, at retirement, that tax is owed. You will pay ordinary income tax on the amount of your withdrawal for that year only; if you have $100,000 in a regular IRA and start withdrawing $10,000 each year starting on your sixtieth birthday, you’ll pay tax on $10,000 of income each year you make the withdrawals. The money remaining in the IRA account is not taxed, even as it continues to accrue dividend and capital gains income.
A Roth IRA works differently. Contributions to a Roth are NOT tax-deductible. These contributions come from your disposable income, but they don’t help you with your tax bill for the year. However, as with a regular IRA, Roth IRAs grow tax free from year to year; taxes are not due on dividend and capital gains earnings.
The difference with a Roth IRA is when you begin to withdraw. All withdrawals are entirely tax free; they don’t count at all toward your taxable income. For most investors, Roth IRAs are the best option. The only disadvantage is, annual contributions are not tax deductible.
Because IRAs are tax-advantaged accounts, the Internal Revenue Service imposes limits on how much an individual can contribute to his or her account each year. If such limitations were not imposed, investors with excess cash — i.e., wealthy investors — would be able to shelter large sums of money that would grow tax free and be withdrawn tax free, leaving the government bereft of tax income. IRA contribution limits are adjusted annually; in 2012, the annual limits are the total amount of your taxable income for the year, or $5,000, whichever amount is less. If you only earned $3,500 of taxable income in 2012, then your IRA contribution limit is $3,500; if you earned $475,000 for the year, then your contribution limit is $5,000.
If you’re fifty years old or older (or if you’re turning fifty during the tax year in question), you can contribute an additional $1,000 “catch-up” contribution to your IRA account, again provided you have at least that much taxable income to match. If you’re over fifty and your taxable income for the year is $5,500, then that’s your maximum allowable IRA contribution. Those over fifty who have earned $6,000 or more can contribute the full $6,000 amount. These extended limits for older workers are intended to allow them to beef up their savings as they get closer to retirement.
Note that contribution limits are identical for regular and Roth IRAs.
As mentioned, these limits are adjusted annually, based on inflation statistics for the current year. As of time of writing (September 2012), the IRS had yet to release IRA contribution limits for tax year 2013; this information is not expected until October or November 2012. However, because inflation has remained relatively low during 2012, it’s unlikely there will be much change in the contribution limit in 2013. In fact, there was no change from 2011 to 2012 (a $5,000 limit, with a $1,000 catch-up contribution for taxpayers aged fifty and more).
If you mistakenly invest too much in a given year, you can reverse the transaction without incurring a penalty. Generally, you have until the day you file your taxes for the year in which the overpayment occurred to reverse the transaction; simply write to your broker or investment house holding the IRA and ask for a Distribution Request Form. Ask for a distribution in the amount of the excess contribution, PLUS any dividend or capital gains earnings that excess amount may have generated in the meantime. Your withdrawal will NOT be a taxable event, nor will it incur a 10 percent early withdrawal penalty.
IRAs are an easy way to maximize your tax-free retirement savings; if you have the extra savings for investment, take advantage of this opportunity before investing in a taxable account.
IRA Calculator will help you determine:
IRA calculator helps you decide whether a Traditional or Roth IRA is best suited for your needs.
How much you need to withdraw each month once you retire to live comfortably
How much you need to contribute each month to maximize employer contribution for monthly retirement withdrawal goal
How you can forecast for your contributions’ affect on your retirement savings can be done through our online 401-K calculator.