The Individual Retirement Account (IRA) is the most important building block in your retirement plan. This is because of the significant tax benefit you will receive if you invest your money within an IRA.
Congress created the IRA in 1974 to provide tax incentives for Americans to save more for their retirement. There are a number of different types of IRAs (Traditional, SEP, SIMPLE, Self-Directed, and Roth). For this article, we will look at the rules associated with a Traditional IRA.
Here’s how a Traditional IRA works:
• Money contributed to an IRA is not taxed that year.
• Interest earned on these contributions is not taxed as long as it remains within the IRA.
• The contributions and interest are taxed when they are taken out of the IRA.
The impact of investing in a Traditional IRA is that your money will grow faster than if you invest your money outside of an IRA. To take advantage of the Traditional IRA tax benefits, you should understand its rules.
For 2011 and 2012, the maximum you can contribute each year is $5,000. If you are age 50 or older, you can contribute up to $6,000. Your earned income must be equal to, or greater than, your IRA contribution.
For example, if you are self-employed and have a profit of $4,500 for the year, the maximum you can contribute is $4,500. The contribution to the IRA does not have to come from the person who earned the money. Let’s say your daughter earned $1,000, but has spent it. You could give her $1,000 so she can contribute to her own IRA.
Whether or not you are eligible to contribute to a Traditional IRA depends on your filing status, your modified adjusted gross income, and whether you are covered by a retirement plan at work.
If you are not covered by a retirement plan at work and you are:
• Single, head of household, a qualifying widow(er), married filing jointly or separately with a spouse who is not covered by a plan at work – you are entitled to contribute the full amount
• Married filing jointly with a spouse who is covered by a plan at work – you are entitled to contribute the full amount if your modified adjusted gross income is $169,000 or less ($173,000 for 2012). You are entitled to a partial deduction if your modified adjusted gross income is more than $169,000 but less than $179,000 ($173,000/$183,000 for 2012).
• Married filing separately with a spouse who is covered by a plan at work – you are entitled to a partial deduction if your modified adjusted gross income is $10,000 or less (2011 and 2012 limits).
If you are covered by a retirement plan at work and you are:
• Single or head of household – you are entitled to contribute the full amount if your modified adjusted gross income is $56,000 or less ($58,000 for 2012). You are entitled to a partial deduction if your modified adjusted gross income is more than $56,000 but less than $66,000 ($58,000/$68,000 for 2012).
• Married filing jointly or a qualifying widow(er) – you are entitled to contribute the full amount if your modified adjusted gross income is $90,000 or less ($92,000 for 2012). You are entitled to a partial deduction if your modified adjusted gross income is more than $90,000 but less than $110,000 ($92,000/$112,000 for 2012).
• Married filing separately – you are entitled to contribute the full amount if your modified adjusted gross income is less than $10,000 (2011 and 2012 limits).
For more details, see IRS Publication 590 Individual Retirement Arrangements.
You can begin withdrawing from your IRA after you reach age 59 ½. If you withdraw before this time you will pay a 10% penalty. Therefore, don’t make a contribution to your IRA unless you are confident that you won’t need the money until then. There are, however, certain circumstances where you can withdraw money before reaching age 59 ½ without paying this penalty:
First-time home buyers: you can withdraw as much as $10,000 for a first home, or $20,000 if you are married and your spouse also has an IRA. Be aware that the time limit from when you withdraw the money and when you spend it is 120 days.
Costs involved with education: This includes all education after secondary education and can be a college, university, or even a vocational college. Costs allowed include more than just tuition, and can be for books, supplies, and even room and board, with certain limitations.
Disability: if you are disabled and cannot work full time you may also withdraw money from your IRA. Your disability will have to be verified by a doctor.
Medical expenses: You may also withdraw money for medical expenses, but the amount cannot be greater than 7.5% of your adjusted gross income. You must show a real need for the money in your IRA to help with your unforeseen medical costs.
Health insurance while unemployed: If you have lost your job and your health insurance, you may withdraw money from your IRA to help pay for premiums on your health insurance. You must have been collecting unemployment insurance for at least one year.
There is also an exception if you are called to active duty in the U.S. Armed Forces or if the IRS has slapped a levy on you.
For details of all these exceptions, see IRS Publication 590.
Note: Once you reach age 70 ½ you must begin withdrawing money from your IRA. The IRS has rules that determine the minimum distribution you must make each year or face a penalty.
Deadlines: You can set up and make contributions to an IRA by the due date of your tax return (April 15). This deadline is the same even if you have an extension to file your tax return.
Don’t let the various rules involving a Traditional IRA get in the way of establishing and contributing to an IRA. It’s vital to retirement planning.