What is an IRA and How Does it Work?

It is never too late to start planning for your retirement.  You should not bet on your Social Security retirement benefits being sufficient to provide the comfortable retirement you may be hoping for.  Instead, plan ahead by using an IRA, which allows you to plan, save and invest in your future retirement.  IRAs can also be used to pay for important purchases, such as your first home, while also providing valuable tax breaks.  What is an IRA and how does it work?  Let’s find out.

An IRA defined

An IRA refers to an Individual Retirement Account, which is essentially a tax-deferred savings plan.  It must be established under the applicable IRS guidelines in order to provide the benefits intended, however. There are four types of IRAs from which to choose, which all tout their own benefits.  Two types, Traditional IRAs and Roth IRAs, are created by individuals, whereas the other two types, Simplified Employee Pensions (SEP) and Savings Incentive Match Plans for Employees (SIMPLE) are established through an employer and include matching investments of some type.  Regardless of the type, IRAs are considered “fully vested,” meaning that all contributions and earnings, including contributions made by employers, belong to the individual.

How do these IRAs differ from one another?

The basic differences relate to when the funds are taxed and when they can be withdrawn without penalty.  Traditional IRAs include funds that are placed into the account “pre-tax,” meaning that the funds contributed are tax-deductible.  Any earnings from investments are not taxed as long as the funds remain in the IRA account.  However, when the funds are withdrawn upon retirement, the money is considered ordinary income and taxed at that point as ordinary income.  Funds in a Traditional IRA can be withdrawn upon reaching age 59 ½.  Both the SEP IRA and the SIMPLE IRA provide the same tax advantages as a Traditional IRA. However, with a Roth IRA, the cash is placed in the account “after-tax,” which means that you cannot deduct your contributions, but when the funds are distributed upon retirement, it will be tax-free.  The funds in a Roth IRA are also available for withdrawal without penalty at age 59 ½.

Maximum contribution limitations

The rules regarding IRA accounts set limitations on the total amount of contributions that can be made to each type of account.  These limitations usually change each year.  As of 2014, the maximum amount of annual contributions for both Traditional and Roth IRAs is $5,500, unless you are age 50 or older, then the limit is $6,500.  There may an exception to that rule.  If your taxable compensation that year is less than the maximum, then you are limited to the amount of your taxable compensation.

The limitations on contributions to an SEP and SIMPLE IRA are higher.  With a SIMPLE IRA, an employee is allowed to contribute no more than $12,000.  This amount will increase in 2015 to $12,500.  The maximum contributions for an SEP IRA is currently, $52,000.  In 2015, the maximum will increase to $53,000.

Penalties for early withdrawal of IRA funds

If you withdraw any funds from a Traditional IRA before you reach age 59½, you will be assessed an additional 10% tax. There are exceptions for qualified educational expenses, the purchase of your first home, and certain medical expenses. Early withdrawals from Roth IRAs are subject to similar rules.

If you have questions regarding IRAs, or any other retirement planning issues, please contact Wilcox Attorneys, PA online or by calling us at (479) 443-0062.