IRA Investment Guide
About the IRA Guide
In this guide, we cover the basics of the Individual Retirement Account (IRA): What it is, what types of IRAs are available, how to rollover an IRA, how to find the best rates on investments, and what the rules and contribution limits are if you are or are not covered by employer-sponsored plan. While this guide provides an overview and general advice, we encourage you to seek the advice of a qualified tax advisor or Certified Public Accountant in order to receive specific information about your individual financial situation.
What is an IRA?
An IRA is a retirement savings account funded with a portion of earned income. Traditional IRAs have been available since 1974. Legislation known as ERISA (Employee Retirement Income Security Act) provided a way for workers who did not have an employer-sponsored retirement plan to save money for the future. Congress incentivized retirement savings by allowing the contribution to be tax deductible. Between 1974 and 1980, the maximum deductible contribution was $1,500. In 2011, it's $5,000 for those under the age of 50 and $6,000 for those between the ages of 50 and 70 ½. Further incentive allowed all earnings within the account to grow tax-free until distributions were made after retirement. The key to the IRA was the assumption that an investor would be in a lower tax bracket after retirement. Investors with a lower income after retirement would be subject to lower marginal tax rates.
As investments grew over the decades, however, it became clear that taxes due after retirement might not be less than those that were owed before. So, as part of the Taxpayer Relief Act of 1997, Congress introduced the Roth IRA. The Roth IRA was not tax deductible, but earnings did grow tax-free. And, once distributions began after age 59 ½, they were tax-exempt. Further, workers were able to contribute to a Roth IRA after the age of 70 ½.
Traditional IRAs are tax-deferred accounts funded with pre-tax dollars. In other words, the contribution you make each year is not taxed in the year that you earn it. For example, if you make $55,000 in 2011 and contribute $5,000 to a traditional IRA, you will pay tax on $50,000, less other deductions. Tax-deferred means that current tax liability is reduced because you are deferring payment of the tax until a later point in the future. With a Roth IRA, taxes are paid in the year the income is earned. For example, if you make $55,000 in 2011 and contribute $5,000 to a Roth IRA, you will pay taxes on the full $55,000.
Even though the contribution made to a Roth IRA isn't tax deductible, its value will always be greater than a traditional IRA with the same account value. That's because the Roth IRA is funded with pre-tax dollars and the distributions are paid tax-exempt.
To see anwsers to 30 of the most common IRA questions, visit the IRA FAQ.
Types of IRAs
Several types of IRAs available to save for retirement: Traditional, Roth, SEP and spousal are just a few of the most well known. As discussed above, a traditional IRA is funded with pre-tax dollars and a Roth IRA is funded with dollars that have already been taxed. SEP IRAs are available for the self-employed, sole proprietors, small business owners, and even those who do freelance work in addition to having a full-time job. SEP IRAs provide tremendous savings and tax-deferral, as the 2011 contribution limit can be as much as the lesser of 25% of total compensation or $49,000. A spousal IRA is a special type of IRA that is funded by a working spouse for one who is not employed outside the home and does not have earned income. It can be funded up to $5,000 or $6,000, depending on the age of the spouse.
For more details about traditional IRAs, see the Traditional IRA page.
For more details about Roth IRAs, see the Roth IRA page.
For more details about SEP IRAs, see the SEP IRA page.
For more details about 457 plans, see the 457 Plans page.
Rolling over your IRA means that you are moving it from one tax-qualified account to another. Contributions that have been made each year along with all of the earnings must be moved into another tax-qualified account in order to avoid a 10% penalty and having to declare the distribution as income for the year. A tax-qualified account can be established at a brokerage house, mutual fund company, bank, savings and loan, or any other financial services company recognized by the Internal Revenue Service as qualified to serve as the custodian.
An IRA can be rolled over once per year. A direct rollover is one in which the account is moved directly from one custodian to another. An indirect rollover occurs when the account is paid to the individual before a new account is established. While the IRS allows an account owner to perform a rollover in either way, it's usually best to request a direct rollover.
For more information no how IRA rollovers work, visit the IRA Rollovers page.
How to Find the Best IRA Rates
The competition among financial institutions for IRA accounts has become increasingly intense. Most companies offer to maintain IRA accounts for little or no management fee, and offer services such as financial planning, free stock reports, and access to helpful retirement planning tools. To find the best rates for an IRA, an account owner needs to understand the best financial instruments for his or her needs. For example, older investors in their 60s and 70s need to maintain at least some portion of their portfolios in stocks in order to provide growth that outpaces inflation. But, they also need to protect their assets. For these investors, certificates of deposit and bond funds are usually the bulk of the portfolio. For younger investors, the best rates and returns will be from stocks. While younger investors still need to diversify, the bulk of their IRA accounts should be made up of stocks.
For tips on how to find the best IRA rates, see the Best IRA Rates page.
IRA Rules and Contribution Limits
Each year, millions of Americans wonder which type of IRA is best for them. The traditional IRA offers a tax deduction while the Roth does not. Neither account will be taxed on earnings, but the Roth will pay distributions free of tax at retirement whereas the traditional IRA will not.
For some, this question is answered by the amount of earned income they have for the year. For 2011, if your tax filing status is "single" and your annual income exceeds $122,000 ($179,000 if you are married and file jointly) your only option will be a traditional IRA. All workers with earned income can contribute to a traditional IRA, but not all workers will be able to take the full deduction. The rules on whether or not a contribution is deductible depend on the amount of money earned and whether or not you are covered by an employer-sponsored retirement savings plan. For example, if your filing status is "single" and you participate in a plan at work, your maximum contribution of $5,000 ($6,000 if you are 50 or older) is only fully deductible if modified adjusted gross income is $56,000 or less.
For more discussion of rules and limits of various IRAs, visit the IRA Rules and Limits.
Not sure which IRA is best for you? Have a look at the Roth vs Traditional IRA page.
Save, Save, Save
Regardless of which type of IRA you choose, it's important to begin saving as much as possible as early as possible. While no one can predict what will happened with the stock market, economy, tax rates, or rate of inflation in the future, it's becoming increasingly clear that a solid retirement cannot be built without a foundation of savings.
Navigating the murky waters of finance can be tricky. There is far more information than we can cover here. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More IRA Guidance
- Traditional IRAs — Details about how traditional IRAs work.
- Roth IRAs — Details about how Roth IRAs work.
- SEP IRAs — Details about how SEP IRAs work.
- Roth vs Traditional IRAs — How to choose the right IRA for you.
- IRA Rollovers — How to roll over an IRA and what to watch out for.
- IRA Rules and Limits — IRA contribution limits explained.
- 457 Plans — Detials of how 457 plans work.
- Best IRA Rates — How to maximize earnings in your IRA.
- IRA FAQ — Over 30 in-depth IRA questions answered.