An Individual Retirement Account is a type of “individual retirement plan,” offered by many financial service companies. An IRA represents a good way for many Americans to save money for their retirement. If your employer offers a 401(k) plan and if it provides matching funds that, without question, should be your first choice for your retirement saving. However, if your employer does not match your contributions or if there is no 401(k) plan where you work then your next best choice would be an IRA. However, before you open one of these accounts it’s important to know the following facts.
There isn’t just one type of IRA
There are several different types of IRAs though the most popular one by far is what’s called a Traditional IRA. The reason that it’s so popular is because the contributions you make to it are often tax deductible or “contributions made with pretax assets” or “money deposited before tax”. The simplest explanation of this is that with a Traditional IRA all the transactions you make and all earnings within your IRA generally have no impact your taxes until you retire and begin making withdrawals. At that point, the money will be taxed as income.
A second type of IRA is called a Roth IRA. It is almost the exact opposite of a Traditional IRA because the contributions you make to it are after-tax as you will pay taxes on them. But all the transactions within a Roth IRA have no impact on your taxes and when you begin making withdrawals the money is generally tax-free. Roth IRAs have become increasingly popular because as your investments within the IRA grow in value they have no impact on your taxes and, as mentioned above, when you begin withdrawing the money at age 59 1/2, it’s generally tax-free.
This type of IRA was created to allow an employer – usually a person who is self-employed or owns a small business – to contribute into a standard IRA in his or her name instead of into the company’s pension fund. The benefits of a SEP IRA are essentially those of a Traditional IRA as described above.
Simple stands for a Savings Incentive Match Client for Employees. This type of IRA requires that whenever one of its employees makes a contribution, the employer must match it. A Simple IRA is very similar to a 401(k) plan but is simpler and less costly to administer and has lower contribution limits.
Since all IRAs are self directed the term “Self-Directed” is basically redundant. The difference here is that the IRA custodian company will allow the owner of the account to invest in a wider variety of alternative investments. As examples of this, the owner of a Self-directed IRA could choose to invest the money in, private stock in a company, real estate, private mortgages, gold, and gas and oil limited partnerships.
How they are funded
You can fund your IRA with cash or cash equivalents. The maximum amount you can contribute to an IRA is $5500 or 15% of your annual income a year, whichever is less. If you are over age 50 you can contribute $6500. Whatever amount you contribute reduces your taxable income by that amount. These funding limits apply to both traditional and Roth IRAs. As an example of this, if you are age 45 and have already contributed $3500 into a Traditional IRA you could then put either $2000 more into a Traditional IRA, $2000 into a Roth IRA, or any combination of these.
Investments that are restricted
Once you have money in your IRA you can direct the custodian company to use tit to purchase most types of securities that are traded publicly as well as those that are non-publicly traded. However, some investments are restricted. For example, you are not allowed to use collectibles such as art, rare coins and baseball cards to fund your IRA. In addition, life insurance cannot be held in an IRA.
Beyond this, some custodial companies have their own restrictions. Many of them allow IRA participants to make investments only in traditional brokerage accounts such as bonds, stocks and mutual funds. IRAs can also hold publicly traded securities such as futures, options or other derivatives though some custodian companies will not allow this.
Withdrawing funds from an Individual Retirement Account
The money in your Individual Retirement Account is your money and you can actually withdraw it at any time although there may be penalties. Once you reach age 59 1/2 you can begin taking distributions without penalties and without having to pay taxes on the money. When you reach the age of 70 1/2 there is a required minimum distribution that you must take each year or the penalty will be 50% of the amount of money that you should’ve taken.
What happens in the event of a bankruptcy?
Our Supreme Court ruled unanimously that a debtor in bankruptcy can exempt her or his Individual Retirement Account, up to the amount necessary for retirement. In 2005 the Bankruptcy Abuse Prevention and Consumer Protection Act expanded the protection for certain IRAs. So now Simple IRAs, SEP IRAs, Roth IRAs and individual IRAs are exempt in the case of a bankruptcy up to at least $1 million without having to show the necessity for retirement.
Borrowing from your IRA
There is a two-month window in each calendar year where you are permitted to borrow money from your Individual Retirement Account . During this window, you could take a 60-day loan from your Traditional IRA interest-free. It’s important to repay the money within that 60-day window and this is calendar days and not business days. If you fail to repay the money within those 60 days, the money will be considered a distribution from the account and you will pay income tax on it. If you take the distribution early – before age 59 1/2 – you would likely incur an additional 10% penalty.
As the following video explains, borrowing from an IRA is basically a short term loan and something you can do just once a year.