Individual Retirement Account (or IRA)
An Individual Retirement Account (or IRA) is a special savings account created to provide for retirement.
Under provisions of the pension-reform act passed by the U.S. Congress in 1974, the Individual Retirement Account (IRA) was authorized to establish an individual, tax-sheltered retirement savings program for workers and unemployed spouses not covered by an employer - sponsored pension or other qualified retirement plan. It also provided for a so - called rollover IRA for any employer - sponsored pension or retirement benefits acquired by a worker who left a job. Assets of either type of IRA had to be held in an account that met the requirements of the U.S. Internal Revenue Service. Many fiduciary institutions agreed to act as sponsors of the programs. These included banks, savings and loan associations, insurance companies, and securities brokers.
For federal tax purposes, taxpayers were able tî deduct the annual amount deposited to the IRA from their gross incomes for the year. Income tax would be deferred on the deposit and on the account's earnings until withdrawal. Any portion of eligible lump-sum payments placed in a rollover IRA within 60 days of receipt acquired federal tax - deferred status.
Tax-reform acts after 1974 revised a number of the original provisions. In 1982-under the rules governing the regular, or contributory, IRA - any employed person who had not attained age 701/2 could contribute $2,000 or 100% of compensation, whichever was less. Each married working spouse could establish an IRA. A working spouse could establish an IRA for a nonworking spouse, in which case total contributions could not exceed $2,250, or 100% of compensation, whichever was less. Withdrawals before age 59 1/2 were generally subject to a penalty tax; withdrawals had to begin when the account holder reached age 70 1/2. By the Tax Reform Act of 1986 the full tax - deductible contribution was limited to workers not covered by employer - sponsored pension plans and to those covered by such plans with an adjusted gross income of less than $25,000 for single people and less than $40,000 for married couples filing joint returns. For those covered by such plans but with an adjusted gross income for single people of between $25,000 and $35,000 and for married couples between $40,000 and $50,000, partial deductions were allowed. In addition, taxpayers could continue to contribute as before to IRA's and have the dividends and interest earned by the IRA investment accumulate free of tax.
Created under federal tax law, an individual retirement account (IRA) is a tax-deferred retirement program in which any employed person can participate. The extent of annual contributions and the tax deductibility thereof are, however, dependent on the individual worker's situation.
IRAs were authorized by Congress in 1974 as part of a broader effort to reform laws governing pensions. Subsequent legislation — and in particular, the Tax Reform Act of 1986 — has refined the scope, provisions, and requirements of IRAs so that currently not only the basic, individual "contributory" IRA but also other forms of the plan are available. As outlined by W. Kent Moore in The Guide to Tax-Saving Investing, these include:
- Spousal IRAs, enabling a working spouse to contribute to an IRA opened for a nonworking partner,
- Third-Party-Sponsored IRAs, used by employee organizations, unions, and others wishing to contribute on workers' behalf;
- Simplified Employee Pensions (SEPs), enabling employers to provide retirement benefits by contributing to workers' IRAs; and
- so-called Rollover Contributions, allowing distributions from an IRA or an employer's qualified plan to be reinvested in another IRA.
While the rules and regulations are quite specific, employees using the basic contributory IRA can generally contribute up to $2,000 per year. Whether or not these contributions are tax deductible depends on the worker's income level and eligibility for an employee pension plan; nevertheless, the dividends and interest earned by the investment accumulate in the account on a tax-free basis. Typically, IRA funds are invested in varied ways, including stocks and bonds, money market accounts, treasury bills, mutual funds, and certificates of deposit.
Those interested in opening an IRA should familiarize themselves with the regulations governing the amounts that may be contributed, the timing of contributions, the criteria for tax deductibility, and the penalties for making early withdrawals. They should also shop around when investigating financial institutions that offer IRAs, in as much as fees vary from institution to institution, ranging from no charge to a onetime fee for opening the account to an annual fee for maintaining the IRA. Still, as Moore noted, "The advantages of IRAs far outweigh the disadvantages...Earnings for either deductible or nondeductible IRAs grow faster than ordinary savings accounts, because IRA earnings are tax deferred, allowing all earnings to be reinvested. Even when withdrawals are made, the remaining funds continue to grow as tax-deferred assets."
Types of IRA
There are a number of different types of IRAs which may be either employer-provided or self-provided plans. The types include:
- Roth IRA - contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William Roth.
- Traditional IRA - contributions are often tax-deductible (often simplified as "money is deposited before tax" or "contributions are made with pre-tax assets"), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted).
- SEP IRA - a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee's name, instead of to a pension fund account in the company's name.
- SIMPLE IRA - a simplified employee pension plan that allows both employer and employee contributions, similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately.
- Self-Directed IRA - a self-directed IRA that permits the account holder to make investments on behalf of the retirement plan.
There are two other subtypes of IRA, named Rollover IRA and Conduit IRA, that are obsolete under current tax law (their functions have been subsumed by the Traditional IRA) but this tax law is set to expire unless extended. What was formerly known as an Educational IRA is now called a Coverdell Education Savings Account.
Starting with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), many of the restrictions of what type of funds could be rolled into an IRA and what type of plans IRA funds could be rolled into were significantly relaxed. Additional acts made some further relaxations of restrictions. Essentially most retirement plans can be rolled into an IRA after meeting certain criteria, and most retirement plans can accept funds from an IRA.
The tax treatment of the above types of IRAs except for Roth IRAs are substantially similar, particularly for rules regarding distributions. SEP IRAs and SIMPLE IRAs also have additional rules similar to those for qualified plans governing how contributions can and must be made and what employees are qualified to participate.
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