Define: Individual Retirement Accounts, Annuity and Arrangements
Individual Retirement Arrangements or Accounts are personal savings plans that give you various tax advantages as an incentive to set aside money for retirement – combining tax savings, possible tax deductions and compound earnings in your favor. What’s not to like?
Just to keep things interesting, IRA can also stand for an Individual Retirement Annuity. This is an annuity contract or an endowment contract purchased from a life insurance company with the same tax advantages as an Individual Retirement Account. These are available to anyone who has taxable compensation - wages, salaries, fees, tips, bonuses, commissions, taxable alimony, and separate maintenance payments.
IRAs are invested, though a trustee and usually a financial institution, in all types of securities, including stocks, bonds, and money market funds. Contributions to IRAs can only be made in cash, and are limited to the lesser of 100 percent of your income, or $4000 if you own only one IRA, and $5000 if you own more than one. If you’re over 50, those amounts become $6000 for both situations. You can buy an IRA, or on rarer occasions, they may also be employer-provided, as IRAs are cheaper to run than other plans like a 401(k) or 403(b). You cannot in any year made deductable contributions both to an IRA and to those other plans.
The upfront advantages to an IRA are:
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The power of compounding.
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Contributions to IRAs may be fully or partially tax deductible, depending on which type of IRA you have and your circumstances – things like age, earned income, and filing status determine what applies.
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Generally, the amounts in your IRA, including earnings, interest and gains, are not taxed until distribution. In some cases amounts are not taxed at all if distributed according to the rules. The benefit here is that you will probably take distribution of these earnings when you retire and you have a much lesser income, so you’re at a lower tax bracket.
There are 11 types of IRAs, but the two most popular for personal use remain the Traditional IRA and the Roth IRA:
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Traditional IRAs – Accounts that may have both deductible and non-deductible contributions, and in which earnings accrue tax-deferred, but will be taxed as ordinary income on withdrawal. Usually contributions are deductible, for tax breaks now and later, but this depends on your income, tax-filing status, and coverage by an employer-sponsored retirement plan. Non-deductible contributions are not taxed on distribution. Withdrawals from a traditional IRA can begin at age 59 ½ and are mandatory by the April following your reaching 70 ½ years of age.
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Roth IRAs – These accounts have the same standards for contributions as a traditional IRA. How they differ is in deductibility of contribution and taxability of distribution . Contributions to a Roth IRA are non-tax deductible, and withdrawals from this type of account are not taxed if they meet established criteria. Those criteria? One of them is that the account be open for at least 5 years. Roth IRAs are good for people considering eventually buying a house - Up to $10,000 in earnings withdrawals are considered qualified (tax-free) if the money is used to acquire a first-time principal residence. The Roth in a Roth IRA comes from Senator William Roth (r-Delaware) who was the chief legislative sponsor.
Like the Traditional IRAs, a ROTH IRA can be either an account or an annuity. The main differences between the two IRAs are the fact that for a traditional IRA you can deduct contributions under most circumstances, and you cannot contribute to the account or annuity after you reach the age of 70 and 6 months. (Get the feeling this is like Shakespeare’s second best bed?)
Below is a simple grid explaining the difference between the two. You can get a more complete comparison of the various retirement accounts here.
| Tradition IRA (Deductible) | Traditional IRA(non-deductible) |
ROTH IRA |
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|---|---|---|---|
| Contributions | $5,000 ($6,000 if age 50+) annual maximum | $5,000 ($6,000 if age 50+) annual maximum | $5,000 ($6,000 if age 50+) annual maximum |
| Pre-tax dollars | After tax dollars (from your net income) | After tax dollars (from your net income) | |
| Earnings | Tax-deferred | Tax-deferred | Federal tax-free |
| Distributions | Taxable on issuance | Earnings are taxable, return of contributions is not taxable | Conditionally, federal tax-free |
| Most begin distributions on the first April after reaching the age of 70 and 6 months. Contributions also cease at this point. | Most begin distributions on the first April after reaching the age of 70 and 6 months. Contributions also cease at this point. | No set date for issuance |