What Is An Ira

Although the term IRA can refer to a number of things from an Irish political group to a famous American composer of showtunes, the typical answer to the question “What is an IRA?” is that it is a retirement account. Different from any regular savings account, an IRA is also tax-advantaged.

Invented in 1986 as a part of President Reagan’s sweeping tax reforms, Individual Retirement Accounts are a vehicle with which people can deposit pre-tax money in an account to be saved for retirement purposes. Since no tax is paid on money placed into the IRA, savers end up able to save more and generate more growth. Income tax is, however, paid on the money that is taken out of the IRA as distributions during the IRA owner’s retirement.

There are some limits on the tax deductibility of an IRA account. If one is married and files jointly but has a spouse with access to a retirement plan at work, the IRA deduction begins to be phased out at an Adjusted Gross Income of $166,000 or more. If one is married and filing separately with a spouse that has access to a retirement plan at work, the IRA deduction is partial and completely phased out with an AGI of only $10,000 or more. For everyone else, contributions to an IRA are are tax deductible up to $5000 or one’s taxable compensation, which ever is less. If someone is 50 or over, the limit is $6000, to allow older workers to catch up.

IRAs are not a panacea. If one is sure that one’s tax rate will be lower later in life, then they can make a great deal of sense. If one expects to have taxes that are the same or higher, though, the benefit is negated. In addition, all distributions taken out of an IRA are taxed as regular income, regardless of if they derive from capital gains which would ordinarily carry a lower tax rate. IRAs are also illiquid. Although they can hold a range of different assets, and a self-directed IRA will allow even more flexibility, allowing for the holding of such assets as non-personal real estate and even gold bullion, there are significant penalties for withdrawal before the age of 59 and a half. Specifically, the penalty is that tax and an additional ten percent penalty will need to be paid on the distribution. These penalties are waived in limited circumstances, including educational expenses for dependents, purchase of a first home, and certain extraordinary medical expenses.

In recent years, the Roth IRA has become another popular option. Simply put, what a Roth IRA is, is the opposite of a traditional IRA. In a Roth IRA, the saver pays taxes on the money that is put in, but the money that is taken out is completely tax free. These accounts are excellent choices for people who are young and in a low tax bracket with a great deal of time for their money to grow.