Individual retirement arrangements (or IRAs) provide a way for you to set aside money for your retirement—for living expenses and to pay for the things you want to do when you have the time to do them, such as traveling or learning new skills. Like other retirement plans, IRAs offer tax advantages—specifically, the potential for tax-deferred or tax-free growth. Tax-deferred means you postpone taxes until you withdraw money later on. Tax-free means you owe no tax on your investment earnings at all, provided you follow the rules for taking the money out of the account. But in exchange for these tax benefits, there are certain restrictions. Here’s what you need to know about IRAs.
What is an IRA?
An IRA may be either an individual retirement account you establish with a financial services company—such as a bank, brokerage firm or mutual fund company—or an individual retirement annuity that’s available through an insurance company. Certain retirement plans, including a simplified employee pension (SEP) and a SIMPLE (Savings Incentive Match Plan for Employees of Small Employers) may be set up as IRAs, though they operate a little differently from those you set up yourself. There is information about these types of plans in IRS Publication 590.
How Does an IRA Work?
Your IRA provider is the custodian for your account, investing the money as you direct and providing regular updates on your account value. Once your account is open, you can select any of the investments available through the custodian. So one key consideration in choosing a custodian is the type of investments you are planning to make.
To participate in an IRA, you must earn income, and you can contribute up to the annual limit that Congress sets. However, you can’t contribute more than you earn. So, for example, if your total earned income is only $2,500 for the year, that’s all you can put into an IRA, even though the contribution limit is higher.
If you’re divorced, you can count alimony as earned income. And there’s an exception to the earned income requirement for nonearning spouses, called a spousal IRA. This type of IRA also has contribution limits (see the Kay Bailey Hutchison Spousal IRA limit information in IRS Publication 590.)
You can put money into your IRA every year you’re eligible, even if you are also enrolled in another kind of retirement savings plan through your employer. If both you and your spouse earn income, each of you can contribute to your own IRA, up to the annual limit.
All IRA contributions for a calendar year must be made in full by the time you file your tax return for that year—typically April 15, unless that deadline falls on a weekend.
TIP: It may be smarter to spread out your contributions over the year, on a regular schedule. That way you don’t have to struggle to pull together the whole amount just before the deadline, or risk putting in less than you’re entitled to contribute. Another reason spreading out your contributions over the year may be smart is that it allows you to take advantage of dollar-cost averaging.
Join me tomorrow when I break down types of IRA’s