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Individual Retirement Accounts: Understanding What it Entails

Individual Retirement Accounts: Understanding What it Entails

If you want to set money aside for your retirement, an Individual Retirement Account (IRA) provides the perfect opportunity. 

There are some tax advantages of IRA – it allows individuals to defer their tax (payment of tax when the money is withdrawn), giving rise to tax-free growth. As long as you follow the rules binding your account, you will not have to pay tax on the money. There are other restrictions you have to observe in exchange for this restriction.


What is an IRA?

An IRA can either be in two forms:

  1. An individual retirement account that you set up with a financial service company like a bank, mutual fund company, or brokerage

  2. An individual retirement annuity that you operate with an insurance company

Some people might prefer to set up retirement plans like a SIMPLE (Savings Incentive Match Plan for Employees of Small Employers) or a simplified employee pension (SEP) as an IRA. Publication 560 of the IRS sheds more light on these.

 

How Does an IRA Work?

Your IRA provider is in charge of your account. Based on your directive, they use and invest the money, providing a regular update on the account. On opening the account, there are various investment plans available from the provider. As a result, before choosing a provider, be sure to know the type of investment plan you want to make.

One requirement for IRA is earning income, and the yearly restriction on what you can contribute is what congress sets. Another contribution limit is what you earn. For people whose annual income is $5000, you cannot contribute more than $5000 in the IRA even if the contribution threshold is higher. 

For divorced people, alimony might be classified as earned income. Non Earning spouses have an exception on their earned income requirement known as spousal IRA. It is an IRA with contribution limits. IRA publication 590 has more details on this. 

As long as you are eligible, you can have money in your IRA account every year. This does not affect your contribution to other types of retirement account. For earning couples, both parties can put cash in their individual IRA till the annual threshold.


Deduction Phase-Out

Everyone cannot remove money from an IRA. Your earning amount, alongside the retirement plan you have, determines if you can withdraw and the amount to deduct. Also, the amount you get to deduct will keep reducing until it phases out completely when your MAGI (modified adjusted gross income) gets to the IRS threshold. 

For a specific tax year, all IRA contributions must be completed as at the time of filing the tax return. This is typically April 15 for every year except on a weekend and exceptional circumstances like this year’s 2020 (CoronaVirus pandemic).


Roth IRA vs. Traditional IRA

A Roth IRA is a particular type of individual retirement account (IRA) that allows qualified withdrawal without taxes as long as owners meet some conditions. While Roth IRA was established in 1997, it is similar to a traditional IRA with some distinctions highlighted below:

  1. Their tax method differs – You can only fund Roth IRA with the after-tax dollar; hence the contribution cannot be taxed. As a result, you won't have to pay tax again when you withdraw the funds. 

  2. Traditional IRA, on the other hand, is funded with pre-tax dollars. Your contribution comes with a tax deduction. Withdrawing the money comes with tax deduction alongside income tax during retirement.


What Can You Contribute to a Roth IRA?

How much you can contribute to a Roth alongside the nature of the money are decisions made by the IRS. Earned income is the only money allowed for a Roth IRA.

For people with employers, the following compensation qualifies for a Roth IRA: wages, salaries, commission, bonuses, and other money paid in exchange for the services rendered. You will typically see the amount you will pay in Box 1 of Form W-2.  

As long as there is a taxable income, anybody can make a payment towards a Roth IRA. However, they need to meet some requirements, as well, in terms of the filing status and the modified adjusted gross income (MAGI).

You might be ineligible to contribute if your annual income rises above a specific limit set by the IRS.

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