Individual Retirement Accounts Explained

Too many Americans postpone or neglect saving for retirement believing Social Security benefits will be sufficient as a primary source of income. In most cases, this is not true. IRAs offer you tax-advantaged ways to make building your retirement nest egg easy. This part of StreetWise explains what IRAs are, how they work, and how they compare to other types of retirement plans.

Individual IRA Plans
401(k), IRA, or Both?

To adequately prepare for retirement, many financial experts recommend you fully fund your 401(k), then deposit the maximum possible in an IRA. A 401(k) plan is a retirement vehicle sponsored by employers. Employees make pre-tax contributions into the plan. The employer matches a portion of the employee's contribution – usually 50% to 100% – up to a percentage of the employee's salary. The match often represents a significant portion of the investment's growth. Tax laws limit the amount of contributions employees can make.

Distributions are taxed upon withdrawal. Generally, the employer contributions are subject to vesting. This means the employee must be in the plan for a pre-set period of time before the contributions totally belong to the employee – even if they change jobs.

When someone leaves an employer, they often get a distribution from their 401(k) and possibly a pension plan. The proceeds of these distributions can be rolled directly into a Traditional IRA (see below) without any taxes or penalties.

Talk to your employer to see if a 401(k) plan is available to you and how to contribute to it. If your employer does not have a plan, opening an IRA is even more essential to your comfortable retirement.

Traditional IRAs

Contributions to traditional IRAs (under certain circumstances) and the earnings on them aren't taxed until withdrawal. At that time, withdrawals are taxed at your income tax rate. Ten percent penalty taxes may apply if you withdraw before age 59½.

You can contribute up to $3,000 a year or 100% of your earned income, whichever is less. If you are married, you can contribute up to $6,000 or 100% of your combined income, whichever is less, between each spouse's IRAs. Workers age 50 and older can play "catch-up" with their retirement savings by contributing up to 100% a year over the maximum contribution limits. You can make contributions up to April 15 for the prior tax year.

You can make tax penalty-free withdrawals for several reasons. You can pay first-time home-buying expenses ($10,000 lifetime limit) for you, your spouse, children, grandchildren, or parents. You can also pay qualified higher education expenses for you, your spouse, children, or grandchildren not covered by other education assistance.

Penalty-free withdrawals are also allowed for death, disability, medical expenses that exceed 7.5% of your adjusted gross income, and to purchase health insurance if you have received unemployment compensation for twelve weeks or more.

Minimum distributions are required beginning at age 70½. If you receive a distribution from a pension, 401(k), or other company retirement plan, you can roll the entire amount into an IRA and defer the taxes until withdrawal.

If you are not covered by an employer-sponsored retirement plan, you can deduct your entire contribution. If you are, it's still deductible if you're single with adjusted gross income (AGI) of $33,000 or less, or married with AGI of $53,000 or less. Many non-working spouses can now deduct $3,000 in contributions even when their spouse is covered by a retirement plan.

Please consult a tax advisor to determine how federal, state, and local tax laws affect IRA deductibility for you and whether a Traditional or Roth IRA is best for your situation.

The Roth IRA

The new Roth IRA offers tax-free growth when you hold it for at least five years and take distributions after you reach 59½. Unlike traditional IRAs, you can keep your account intact beyond age 70½ and can continue to make contributions. Being covered by a retirement plan doesn't affect your ability to contribute.

You can make tax penalty-free withdrawals for several reasons. You can pay first-time home-buying expenses ($10,000 lifetime limit) for you, your spouse, children, grandchildren, or parents. Penalty-free withdrawals are also allowed for death, disability, medical expenses that exceed 7.5% of your adjusted gross income, and to purchase health insurance if you have received unemployment compensation for twelve weeks or more.

If you're married with adjusted gross income (AGI) below $160,000, or single with AGI below $110,000, you can make annual contributions – up to $3,000 if AGI is $150,000 or $95,000 respectively. If your AGI is under $100,000, you can roll your existing IRAs, deductible and non-deductible, into a Roth IRA without penalty. However, if you do, you'll owe income tax on all previously untaxed contributions and earnings.

Please consult a tax advisor to determine how federal, state, and local tax laws affect IRA deductibility for you and whether a Traditional or Roth IRA is best for your situation.

Which One Is Right For You – Traditional or Roth?

Deciding which type is best and whether to transfer your current accounts to a Roth IRA is a complicated decision. You must consider your current and future tax brackets, other assets available, your age, your planned retirement age, and whether you built your current IRAs with deductible or non-deductible contributions. You also need to consider any other retirement investments you have. You can have both types of IRAs, but combined contributions can't exceed $3,000 a year. Your tax advisor can help you weigh these and other factors to make the best decision.

In general, a Traditional IRA may be better if you don't participate in an employee-sponsored retirement plan, expect to be in a lower tax bracket at retirement, and need the tax deduction. A Roth IRA may be better if you expect to be in the same or a higher tax bracket at retirement and you're starting at age 18 to 44. Because there is no mandatory distribution age, a Roth may also be better if you won't need your IRA for living expenses and want to leave sizable assets to your heirs.

When converting a Traditional IRA to a Roth, a good rule of thumb is to consider it if you can afford to pay the taxes from other savings or current earnings, or if you won't need the IRA funds during retirement and want to pass funds to your heirs. You generally should not convert if you are within five years of retirement or will need to dip into the IRA to pay the taxes.

Coverdell Education Savings Account
(Formerly known as an Education IRA)

The Coverdell Education Savings Account is not an IRA at all, but a new way to save for qualified higher education expenses such as tuition, fees, books, supplies, and equipment (including the purchase of a computer, educational software and internet access) required for college, vocational, public and private elementary and high schools.

Education Savings Accounts are available only to children under 18. Each child can receive up to $2,000 per year in after-tax contributions from relatives and friends whose adjusted gross income (AGI) is $220,000 or less if married, or $110,000 if single. Earnings grow tax-free.

Contributions can be made for beneficiaries with special needs (determined by The Treasury) over age 18. CESA balances for those with special needs are not required to be distributed by age 30.

Distributions taken after five years are tax free and must be used for qualified higher education expenses. Tax penalties apply for early withdrawals and use for non-qualified expenses.

Please consult a tax advisor to determine how federal, state, and local tax laws affect Education Savings Accounts.

Source: DCU StreetWise - ((http://www.dcu.org/streetwise/howto/ira-index.html))