A key savings goal for many people is retirement. To make it easier to reach that goal, the U.S. tax code offers a lot of advantages for saving through an Individual Retirement Account, sometimes called an Individual Retirement Arrangement, but most commonly known as an IRA.
The bad news is that in trying to cover so many bases, the rules quickly become complicated. The IRS has all the details; this is a simplified version with enough information to get you started.
Here are five things you need to know to set up an IRA account:
- IRAs are designed for people who have jobs but do not have a retirement plan at work. You can contribute $5,500 a year if you are under age 50 and $6,500 a year if you are 50 or older. This is the maximum; if you can only contribute a smaller amount, that’s OK. If you are covered by a retirement plan at work, you can still contribute to an IRA as long as your income is below $69,000 for single filers and $115,000 for married filers. These are 2013 numbers that are revised each year.
- A traditional IRA allows for tax-deductible contributions, but the income earned on the investment is taxed in retirement. With a Roth IRA, the contribution cannot be deducted, but the income earned on it is not taxed, either. And, you can take the amount that you contributed to the account out at any time (although you can’t take out the earnings on those contributions until you turn 59 1/2). Up to $10,000 in earnings and contributions can be taken out of a Roth IRA to finance the purchase of a first house, too.
- The IRA is designed for people who earn money, but the law allows a spouse who is not employed to contribute to an IRA. This is known as a spousal IRA. It is a great way for a family to increase its savings. It also recognizes that there is an economic contribution to the work of running a household and caring for a family. A spousal IRA contribution cannot be deducted on the tax return for a family earning more than $188,000 if the working spouse is covered by a retirement plan, and the contribution cannot exceed the family’s earned income.
- After you make the decision to contribute to an IRA account, you need to decide where to put the money. Almost all banks and mutual fund companies can handle this for you. A bank account will be safe but offer very little return, especially relative to inflation; a mutual fund invested in stocks will have a better long-term return but a lot of volatility in between. Although the IRS does not set a minimum for IRA contributions, many financial institutions do set one, so check with the individual company.
- Once the money is set up for retirement, the account probably shouldn’t be touched except to move it into an investment that is a better fit for your changing needs. A traditional IRA will be assessed a 10% penalty tax on most withdrawals made when you are younger than 59 1/2, unless the account holder becomes disabled or dies. After age 70 1/2, you must start taking distributions from the account. A Roth IRA will not be assessed the penalty tax unless the earnings are taken along with the amount contributed.
What’s better, Roth or traditional? That depends. If you are in a retirement plan and still qualify for an IRA contribution, setting up a Roth IRA will give you more flexibility than a traditional plan. If you need the tax deduction now, then the traditional IRA is the better option.