How Exactly Does an IRA Work?

In 1974, Congress introduced a tax-incentive program known as the Individual Retirement Account to encourage long-term retirement saving. Anyone with earned compensation who is less than 70 years and six months old may open an IRA. Most individuals select either a traditional IRA or a Roth IRA. Each has restrictions depending on income and employment status, a maximum contribution limit and penalties for noncompliance. Establishing an IRA takes no more effort than completing a job application.

Things You'll Need

• Income information or latest tax return
• Employment information
• Bank account information
• Beneficiary name, address, social security number
• Initial cash contribution
• Photo ID

Instructions

Traditional or Roth IRA

1. Compare your adjusted gross income to the income limits of Roth IRAs. If your AGI exceeds these limits, your only option is a traditional IRA. For the 2011 tax year, married, joint filers and widow(ers) with an AGI between $90,000 and $110,000; single or head of household filers with an AGI of $56,000 to $66,000 and married, separate filers with an AGI less than $10,000 can contribute to a Roth IRA.

2. Weigh the importance of a tax deduction for traditional IRA contributions to paying taxes on Roth IRA contributions. Deductible contributions and earnings of traditional IRAs are taxed when you withdraw them. Withdrawals of Roth IRA contributions and qualified earnings can be made tax-free.

3. Project your tax bracket for your retirement years. If you anticipate being in a lower tax bracket when you retire, you may find a traditional IRA to be your best choice. If you think your tax bracket will be the same or higher than your current bracket, a Roth IRA could be more advantageous because you pay taxes at today’s rate on today’s contributions.

Trustee Selection

1. Investigate potential trustees for the IRA you chose. Conduct online research as well as seek advice from financial professionals whose opinions you trust to create a list candidates.

2. Compare the fees charged as well as services and investment options offered by the banks and financial institutions under consideration before deciding which you will use.

3. Choose the type of asset in which you wish to invest. Options include certificates of deposit, stocks, annuities, mutual funds, bonds or other assets, such as real estate.

4. Complete the required forms online and arrange for an electronic transfer of your initial contribution. Remember to bring your photo identification plus information related to employment, beneficiaries and banking when opening your IRA in person.

5. Decide how much and how frequently you will contribute to your IRA. As of 2011, the maximum annual contribution is $5,000 ($6,000 for those aged 50 to 70 years and six months) or taxable compensation for the year, whichever is smaller. The IRS requires all contributions to be in the form of cash. You can set up automatic withdrawals from their checking or savings accounts for direct deposit into their IRA.

Monitoring

1. Keep records of your investments. Review the quarterly and year-end statements for overall investment performance. Check the 1099-R form sent by the trustee for discrepancies.

2. Review your contribution level and income if your marital status changes or you get a raise that might put you into a higher income bracket or different AGI status.

3. Remember to begin mandatory withdrawals from your traditional IRA when you reach 70 years and six months of age.

Reporting

1. Use the information provided on the 1099-R form you receive from your trustee to report IRA activity on your federal tax return.

2. Enter any deductions related to contributions on line 32 of Form 1040, or line 17 of Form 1040-A.

3. File Form 8606 to report any non-deductible contributions even if you are not required to file a tax return that year. You may be subject to a $50 penalty for not filing this form.

4. Consult a tax specialist with questions about any additional forms related to special circumstances as necessary.

Tips & Warnings

• Consult a tax expert to make sure you do not overlook any tax-deferral opportunities or incur penalties that could be avoided.

• Self-employed people can save using a Simplified Employee Pension IRA, while small business owners can use Savings Incentive Match Plan for Employees IRAs.

• The deadline for making an IRA contribution for a given tax year is your federal tax return filing due date, excluding extensions. For example, in the 2011 tax year, the deadline is April 17, 2012.

• Advise your trustee if the contribution you make between January 1 and April 17, 2012 should be assigned to 2012 or 2011; otherwise the trustee will assume the contribution is for the current year (2012).

• Consider contributing your Federal income tax refund to your IRA. The IRS will direct deposit all or part of any refund you are due directly into your IRA account.

• Annual contributions to a traditional IRA are not required even if you have compensation that makes you eligible to contribute. However, according to the IRS, you will not be eligible to make a contribution in any year you have not worked unless you file a joint tax return with a spouse who earned compensation, or received alimony or military or nontaxable combat pay.

• CNNMoney suggests those eligible for both types of IRA who also participate in an employer-sponsored, tax-deferred 401(k) plan consider adding a Roth IRA to their retirement portfolio.

• Understand that withdrawals you make prior to reaching age 59 years and six months incur a 10 percent penalty.

• Spouses cannot share an IRA; they can, however hold separate IRAs.

• You cannot make any contributions to a traditional IRA in the year you become 70 years and six months old.

• Your IRA funds cannot be used to purchase life insurance.

• Failure to report non-deductible contributions could lead to tax obligations on all contributions.

• Wells Fargo Bank notes that Roth IRA earnings must be held for five years to qualify for federal tax-free status.

References

• Congressional Research Service: Individual Retirement Accounts (IRAs) Issues and Proposed Expansion
• U.S. Department of Labor: Employee Benefits Security Administration; New Employee Savings Tips - Time Is On Your Side
• Internal Revenue Service: Publication 590 - Individual Retirement Arrangements (IRAs)
• Choose to Save: Why Open an IRA?
• CNNMoney: Ultimate Guide to Retirement - How Do I Know If a Traditional IRA Is Right For Me?
• Wells Fargo: Compare Traditional vs. Roth IRA
• CNNMoney: Ultimate Guide to Retirement - Where Should I Open an IRA?
• CNNMoney: Ultimate Guide to Retirement - What is a SEP IRA?
• CNNMoney: Ultimate Guide to Retirement - What is a SIMPLE IRA?

Resources

• Equity Trust Company: Basic Information on Self-directed IRAs