What is an IRA

The term IRA gets tossed around when talking about investments, but have you every wondered what exactly an IRA is?

The letters in IRA stand for Individual Retirement Account.

An IRA is not actually an investment, such as a stock or a bond is an investment.  Instead an IRA is an account where you hold your investments.

Why the special account?  IRA’s were designed to be used as a retirement savings tool that protects your investments from taxes and you getting at the money before it is retirement time.

The best way that I have heard to describe it is that it is a coat that you wrap around your investments.  Why would your investments need a coat?

Just like a real coat protects you from the cold, an IRA is protecting your money from taxes.  The less you pay in taxes the more your money will grow due to compounding.

Benefits of an IRA:

  • In a traditional IRA the money can be deducted from your earnings this year, thus giving you a smaller tax bill now.  There are income limits on this and there are some ways around the income limits if your employer does not offer a 401K, please check with your accountant to see what the current requirements are and if you meet them.
  • The money in the account grows tax free.  Any gains on investments outside a tax sheltered account will be taxed the year your receive the income.   In an IRA you don’t pay taxes on those gains.  This allows your money to grow longer before you need to give the government it’s share!
  • You can do a non-deductible IRA if you make more money than is allowed for your deduction now.  This allows you to at least take advantage of tax free growth.  (And if you make too much to do a ROTH IRA then you can do a non-deductible IRA and roll it to a ROTH as there are no limits on how much you make to do a rollover).
  • Creates a stop and think barrier before you take the money out before it is time!  If you make a withdrawal before the age of 59 1/2 then there is a penalty of 10%, a hefty penalty to tap your saving before it is time, thus making it more attractive to leave the money to sit and grow. (There are some times you can withdrawals for a hardship and not pay the 10%, check with a CPA to find out the rules).

Other Details:

  • You must begin making withdrawals at the age of 70 1/2
  • You can put any investment into an IRA – stocks, bonds, mutual funds, savings account, CD’s, even rental properties.
  • Most traditional accounts are held at a bank or brokerage company.  Self directed IRA’s are typically at specialty custodian companies.
  • The contribution limit for 2012 is $5,000 for those under the age of 50.  For those over 50 it is $6,000 (Check the IRS website for future years contributions.)
  • Contributions cannot exceed your income for the year.  So even if the limit is $5,000 if you only made $4,000 you can only put in the $4,000.
  • You and your spouse can have separate IRA’s.  You can contribute to a stay at home spouses account as long as one spouse has the income to cover both person’s contribution.  So if you make $10,000 you can fund an IRA for both your spouse and yourself.  If you made $8,000 you could fully fund one and then $3,000 of the other persons.
  • No age limit to start an IRA, only requirement is that you have income.  So your high school kids has a summer job, they can open an IRA.  The benefits of this are huge, as that money then has a really long time to grow!  For example if your child was 16 and put in $5,000, made 8% on the money until they were 65 it would be $248,745 and that is if they never added another penny!
  • You can contribute for the current year up until April 15th of the next year.  In other words if you want to make a 2011 contribution you don’t have to do so until April 15, 2012!  This allows you time to work with your accountant to see the impact of deductions and a possible savers credit (credit from IRS for contributing to retirement).

Hope that helps a bit!

You can use this as a spousal IRA also – for more information on that: Spousal IRA

Matt says December 8, 2011

I didn’t realize that I had all the way up to April 15, 2012 to contribute for the 2011 tax year. That is good to know. I have never been very good at consistently putting money away into my ROTH IRA. I maxed it out my first year in 2007, but since then it has been $100 here, $50 there. I think in 2011 I managed to put away $800 into my IRA, which is better for past years. I find it difficult to find the money to contribute $5,000 though.

    Andrea says December 8, 2011

    I love that we get til tax due day to figure put contributions in, makes tax planning for that easier! Do you just put extra money into the ROTH or is it something you do actually want to get the money in for? If you do want to get it all in then I would recommend setting up an automatic withdrawal once a month. Takes the effort out. Otherwise what I do is make that contribution part of my tax process when I am working on them in February. My CPA usually reminds me as part of his process also!

Steven J Fromm says June 21, 2013

IRAs are a very important part of putting money away for retirement or as a supplement to other retirement plans. With the uncertainty of social security benefits and the small amounts companies put into plans for their workers, it is almost essential to supplement and save for retirement. IRAs are a great vehicle to use to build retirement assets.

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