IRAs Provide a Tax-Advantaged Way to Invest for Retirement - dummies

IRAs Provide a Tax-Advantaged Way to Invest for Retirement

By Paul Mladjenovic

Individual Retirement Accounts (IRAs) are stock investing accounts you can open with a financial institution, such as a bank or a mutual fund company. An IRA is available to almost anyone who has earned income, and it allows you to set aside and invest money to help fund your retirement.

Opening an IRA is easy, and virtually any bank or mutual fund can guide you through the process. Two basic types of IRAs are traditional and Roth.

Traditional IRA

The traditional Individual Retirement Account (also called the deductible IRA) was first popularized in the early 1980s. In a traditional IRA, you can make a tax-deductible contribution of up to $5,000 in 2011 (some restrictions apply). Individuals age 50 and older can make additional “catch-up” investments of $1,000. For 2012 and beyond, the limits will be indexed to inflation.

The money can then grow in the IRA account unfettered by current taxes, because the money isn’t taxed until you take it out. Because IRAs are designed for retirement purposes, you can start taking money out of your IRA in the year you turn 59–1/2. The withdrawals at that point are taxed as ordinary income. Fortunately, you’ll probably be in a lower tax bracket then.

Keep in mind that you’re required to start taking distributions from your account when you reach age 70–1/2 (that’s gotta be a bummer for those who prefer the age of 71–7/8). After that point, you may no longer contribute to a traditional IRA. Again, check with your tax advisor to see how this criteria affects you personally.

If you take out money from an IRA too early, the amount is included in your taxable income, and you may be zapped with a 10 percent penalty. You can avoid the penalty if you have a good reason. (The IRS provides a list of reasons in Publication 590, “Individual Retirement Arrangements.”)

To put money into an IRA, you must earn income equal to or greater than the amount you’re contributing. Earned income is money made either as an employee or a self-employed person. The toughest part about traditional IRAs is qualifying — they have income limitations and other qualifiers that make them less deductible based on how high your income is. See IRS Publication 590 for more details.

Though IRAs usually involve mutual funds or bank investments, stock investors can open a self-directed IRA with a brokerage firm. This means that you can buy and sell stocks in the account with no taxes on dividends or capital gains. The account is tax-deferred, so you don’t have to worry about taxes until you start making withdrawals. Many dividend reinvestment plans (DRPs) can be set up as IRAs as well.

Roth IRA

The Roth IRA is a great retirement plan. Here are some ways to distinguish the Roth IRA from the traditional IRA:

  • The Roth IRA provides no tax deduction for contributions.

  • Money in the Roth IRA grows tax-free and can be withdrawn tax-free when you turn 59–1/2.

  • The Roth IRA is subject to early distribution penalties (although there are exceptions). Distributions have to be qualified to be penalty- and tax-free; in other words, make sure that any distribution is within the guidelines set by the IRS (see Pub. 590).

The maximum contribution per year for Roth IRAs is the same as for traditional IRAs. You can open a self-directed account with a broker as well. See IRS Publication 590 for details on qualifying.