IRA Basics

IRA is an acronym for Individual Retirement Account. In general, there are two types of IRAs – Traditional and Roth. IRAs were created to help us save for retirement.  

A Traditional IRA helps you save for retirement in two ways. First, you may get an income tax deduction when you deposit money in the account. Second, there is no tax on the growth in the account. You pay tax only on the amounts you withdraw when you retire.

The major difference between a Traditional and Roth IRA is when the money is taxed. In a Roth IRA, you deposit after-tax money in the account, but you do not pay any tax when you withdraw the money.

The second key concept to understand is that an IRA is a type of account, not an investment on its own. To relieve some confusion, the IRS has recently started to refer to an IRA as an Individual Retirement Arrangement, instead of Account. Once you deposit money into an IRA, you will need to determine how to invest it. Within the IRA, you can put your money in Certificates of Deposit (CD), mutual funds, individual stocks or annuities.

Now for the fine print. While there are many details and complexities, the biggest issues for most people are do they get a tax deduction for their contribution and what if they need the money before they retire.

In government-speak, you must have “earned income” (a tax term that refers to wages and some other items) to contribute to an IRA. In other words, if you have a job, you can contribute.  The real limitations start now. For Traditional IRAs, if you have a retirement plan at work such as a 401(k) or a pension plan, you can still contribute to the account. However, you many not be able to take a tax deduction if your Adjusted Gross Income (AGI) is too high. For a Roth IRA, you can only make a contribution if your AGI is below a certain dollar amount. These limits change every year, so you can go to IRS Publication 590 to find the most current rules.  

The other piece of bad news is what happens if you need the money before you are age 59½. In a Traditional IRA, you not only pay income tax on the withdraws, the government adds a 10% penalty on top of the income tax. For a Roth IRA, only the 10% penalty is assessed since you already paid income tax on the money.