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Individual Retirement Accounts, most commonly referred to as IRAs, have allowed the public to secure their own retirements outside of pension plans and Social Security benefits. As an investment that allows tax-deferred growth, or tax deferment, a well-funded IRA provides a much-needed financial cushion upon retirement.
But this wasn’t always the case. Originally authorized by the Employee Retirement Income Security Act in 1974, shortened ERISA, only employees who didn’t have a pension were eligible to invest. Since the Economic Recovery Act of 1981, all workers who report earned income on their tax return can use IRAs to prepare themselves and their spouses for retirement.
Whether you’re covered by a pension plan or a traditional 401(k) or don’t have a retirement plan through your employer, investing in an IRA can help you work towards your retirement goals. As an investment with tax-deferred growth, an IRA gives you the flexibility you need to max out your retirement contributions. You can set up an IRA in addition to a 401(k), but you can also use it to provide a pension for a not traditionally employed spouse.
Most people are familiar with traditional IRA accounts. These accounts are established by an individual with earned income for either their own benefit, their non-working spouse's benefit, or both. Tax deductibility of contributions is dependent upon income level. With this type of investment account, the retirement fund grows on a tax-deferred basis. Your annual contribution to the account is capped at the lesser of the allowable annual contribution or your earned income for the year. Required minimum distributions start at age 72 and the tax deferred portion of the distribution is taxed as ordinary income. It’s also important to understand that, in most cases, you cannot access your retirement funds before the age of 59½ without incurring a penalty for early withdrawal and paying taxes on the tax deferred portion of the distribution.
With a Roth IRA, contributions to the retirement account are not tax deductible. However, distributions from the account after age 59½ are tax free. Whether you’re eligible to directly contribute to a Roth IRA depends on your income. If eligible to contribute, the contribution limits are the same as those for Traditional IRAs and, likewise, growth is on a tax-deferred basis. One advantage over the Traditional IRA is that there are no required minimum distributions, regardless of age.
Generally, SEP IRAs, or Simplified Employee Pension accounts are established by independent contractors and other self-employed people for their own benefit. Contributions reduce the employer's taxable income.
An employer can set up a SIMPLE IRA for the employee. The acronym stands for Savings Incentive Match Plan for Employees. SIMPLE IRAs are similar to 401(k)s in that employees make tax-deductible contributions to the account and the employer can make a matching contribution up to a certain amount.
401(k) and 403(b) Plans are examples of retirement plans set up by your employer. As an employee, you don’t get to choose which plan to participate in. It depends on what your employer offers. IRAs are retirement accounts that employees set up for themselves. All of these retirement accounts allow employees to grow their investments on a tax-deferred basis.
However, the contribution limits are significantly higher for the employer-sponsored plans. The employer may also match your contributions, which allows your nest egg to grow faster. The downside to 401(k)s and 403(b)s compared to IRAs is that they often allow for fewer investment options. For a couple with one non-working spouse, making contributions to an IRA is the only way to build a nest egg for that partner.
Regardless of whether you or your spouse are covered by a traditional retirement plan at work, you can contribute up to the maximum allowable annual contribution amount of $6,000 ($7,000 if you’re over age 50) or your gross earned income if less than $6,000.
Anyone under the age of 70 who has taxable earned income can open an IRA and make contributions to it. IRA contributions cannot exceed your earned income. Earned income excludes passive investment income such as dividends and interest.
You can contribute to your spouse’s IRA if you file a joint tax return and have a combined earned income that’s greater than the contribution limits.
With an IRA, you can invest in almost anything, including stocks, bonds, EFTs, mutual funds, annuities, and alternative investments. An IRA allows you full control over and flexibility regarding your investments.
Investing in an IRA can make a big difference for your retirement, but sifting through the different options can be overwhelming. A financial advisor can simplify the process for you and figure out exactly what type of retirement planning is ideal for you and your family. At Plan 4, Inc., we optimize your IRA planning process, giving you the confidence you need. Call us today to discuss your situation!
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.