Explain What an IRA Is

IRA allows savings with a tax break

An IRA is an individual retirement account. This type of retirement savings account allows you to invest your money with certain tax benefits. You can invest some of your income tax-free, paying pay taxes on the principal and the earnings only when you withdraw the money from the IRA. Or, you can invest money that's already been taxed, defer interest on earnings, and avoid paying taxes when you withdraw the money. You can open an IRA on your own rather than go through your employer.

Types

There are four types of IRAs. Traditional IRAs allow you to invest money tax-free, and pay taxes on the principal and earnings when you withdraw them.

Roth IRAs allow you to invest money that's already been taxed and avoid paying taxes on withdrawals or distributions.

A SEP IRA allows self-employed people and small-business owners to make tax-deductible contributions for employees.

A SIMPLE IRA is like a SEP IRA, except employees are also allowed to make contributions.

Considerations

IRAs have contribution limits. If you are younger than 50, you can contribute up to $5,000 each year; $6,000 if you are older than 50. You might be penalized if you contribute too much.

With a SEP IRA, you can contribute up to 25 percent of your income, or $49,000; $54,500 if you're older than 50. A SIMPLE IRA allows you to contribute up to $11,500, and it requires your employer to make a partial match equal to between 1 percent and 3 percent of your compensation.

Benefits

You can take a tax deduction for money that's contributed to a traditional IRA, SEP IRA, or a SIMPLE IRA. This tax deduction will reduce your taxable income, and it can be taken even if you do not itemize. There is no tax deduction for contributions to a Roth IRA.

One of the biggest advantages is that your IRA investment grows tax-free until you withdraw the money. If you invest in a traditional IRA, you won't pay taxes on the principal or earnings as long as you wait until retirement age to withdraw the money.

Warnings

IRAs have restrictions on when money can be withdrawn. Penalty-free withdrawals cannot be made from an IRA until you reach age 59 ½. There are some exceptions. For example, you can withdraw contributions, but not earnings, from a Roth IRA before age 59 ½ without paying a penalty.

You also may make penalty-free early IRA withdrawals to pay for college expenses, certain medical expenses, disability, or the purchase of your first home.

Requirement

You are required to make withdrawals from a traditional IRA once you reach age 70 ½. The Internal Revenue Service has defined minimum required withdrawals that are based on your life expectancy and your IRA balance. You will be penalized if you don't make at least your minimum required withdrawal. There is no minimum required withdrawal on a Roth IRA.

References

• IRS.gov: Publication 590 Individual Retirement Arrangements
• IRS.gov: 2010 IRA Contribution and Deduction Limits
• CNN Money: What is a SIMPLE IRA?
• CNN Money: What is a SEP IRA?
• CNN Money: What is an IRA?