Key Points
Investors have two options for their individual retirement
accounts (IRAs). The first option is a traditional IRA, and the
second option is a Roth IRA (named for the account's congressional
sponsor), which features -- among other benefits - the ability to
receive tax-free earnings under certain circumstances. In this
report we'll discuss the features of the traditional IRA. You may
want to review material outlining the Roth IRA - or talk to your
financial planner - before you make a decision as to which IRA is
right for you.
What Is a Traditional IRA?
An individual retirement account allows your investment earnings
to grow tax deferred until withdrawn, typically at retirement.
Generally, if you have earned income or receive alimony, you can
establish as many IRA accounts as you want prior to the tax year in
which you reach age 70½. You may also have an IRA even if
you participate in a qualified pension, profit-sharing, or other
retirement plan. Your entire contribution may not be deductible on
your income tax return, depending on your income and your
eligibility for an employer-sponsored retirement plan.
IRAs offer two distinct advantages in terms of taxes: potential
deductibility of contributions and tax deferral on investment
earnings.
Rules on Contribution Limits
In 2011, the maximum annual contribution is $5,000 (in general,
married couples filing jointly can contribute a total of $10,000,
even if only one spouse has income). Thereafter, the contribution
limit will be adjusted for inflation. Individuals aged 50 and older
are now able to take advantage of "catch up" contributions to IRAs.
The allowable catch-up contribution is $1,000 per year. Maximum
contributions may not exceed earned income.
In addition, you can open an IRA or make contributions to an
existing IRA as late as the deadline for filing a tax return for
that year. That means you would have until April 2012, to make your
2011 IRA contribution.
Tax Treatment of IRAs
Contributions to a traditional IRA may or may not be deductible
from your earned income in a given tax year depending on your
situation. Income limits apply if either you or your spouse
participates in an employer-sponsored retirement savings plan.
Deductibility is phased out over certain ranges of income as
follows:
| Traditional IRA Deductibility
Phaseout Ranges for 2011* |
| $ in Thousands |
|
Single Filers |
Joint Filers |
| Those covered by an employer-sponsored retirement plan |
$56-$66 |
$90-$110 |
| Those not covered by an employer-sponsored retirement plan, but
filing a joint return with a spouse who is covered |
N/A |
$169-$179 |
| *Based on modified adjusted gross income
(MAGI). |
The Magic of Tax-Deferred Compounding
The ability to make tax-deductible contributions to a
traditional IRA can help your current tax situation. But you may
want to invest in an IRA whether or not your contributions are
deductible. Why? The real advantage of investing in an IRA is
tax-deferred compounding of your investment earnings over the long
term.
For example, if you had contributed $100 every month for 30 years
to a tax-deferred IRA, then paid 25% tax on your withdrawals at
retirement, you could have netted $112,522, assuming an 8% average
annual rate of return. However, in an account that's taxed annually
at a hypothetical rate of 25%, your total would have been only
$100,954 - almost $12,000 less just because you had to pay taxes up
front!1
| Consider the Advantage of Tax Deferral |
 |
| As you evaluate the potential benefits of an IRA, consider the
advantage of tax deferral. This chart shows the result when a
hypothetical $100 monthly investment is made for 30 years in a
tax-deferred plan versus the same investment taxed annually at a
hypothetical rate of 25%, assuming an 8% average rate of return
compounded monthly. If the final tax-deferred amount is withdrawn
at retirement and taxed at a hypothetical rate of 25%, it exceeds
the taxable final amount by nearly $12,000. |
Change Jobs, But Keep Your Retirement Money
IRAs can also come in handy when you're about to leave jobs and
need to move your 401(k) money. If your former employer requires
that you withdraw your retirement money, you can move your
distribution safely from your former employer's qualified
retirement plan into a rollover IRA and avoid owing current income
tax on the distribution.
If you choose to physically receive part or all of your money and
do not replace the entire amount within 60 days, you will be
subject to penalty fees and taxes on the amount kept.
Withdrawing From Your IRA
Generally, any distribution you receive from an IRA before the
day you reach age 59½ is subject to a 10% penalty tax
imposed by the IRS, in addition to federal and state income tax.
Beginning at age 59½, you can withdraw money (of which any
deductible contributions and investment earnings are taxable at
your then-current income tax rate) from your IRA as desired without
penalty, whether or not you are still employed.
But, as with any rule, there are exceptions. Distributions before
age 59½ are not subject to the penalty tax under certain
circumstances, including when:
- You become permanently disabled.
- You die before age 59½ and distributions are made to
your beneficiary or estate after your death.
- You make withdrawals to pay deductible medical expenses that
exceed 7.5% of your adjusted gross income.
- You make withdrawals for a qualified first-time home purchase
(lifetime limit of $10,000).
- You make withdrawals to pay qualified higher education expenses
for yourself, a spouse, children, or grandchildren.
By April 1 following the year in which you reach age 70½,
you must begin withdrawals from your IRA. A great advantage of
taking only the required minimum distribution amount is that the
balance continues to compound tax-deferred. However, if your
distributions in any year after you reach age 70½ are less
than the required minimum, you will be subject to a penalty tax
equal to 50% of the difference.
Consult Your Financial Advisor
An IRA can become the cornerstone of your personal retirement
savings program, providing the foundation for your financial
security. That's why it is so important to start planning today.
Consult with your financial advisor to help you determine how an
IRA could help make your financial future more secure.
Points to Remember
- If you have earned income or alimony, you can establish as many
IRA accounts as you want prior to the tax year in which you reach
age 70½. Keep in mind, however, that you may be incurring
annual account fees for each account, so maintaining multiple
accounts may not be a prudent decision.
- Contribution limits are $5,000 or 100% of your earned income,
whichever is less. Special "catch up" contributions of $1,000 are
also available to individuals who are at least 50 years old.
- You can open an IRA or make contributions to an IRA as late as
the tax-filing deadline for that year.
- Income limits restricting the deductibility of contributions
apply if either you or your spouse participate in an
employer-sponsored retirement savings plan.
- A major advantage of investing in an IRA is tax-deferred
compounding of earnings.
- By April 1 following the year in which you reach age
70½, you must begin withdrawals from your IRA.
- Individuals under the age of 59½ can make penalty-free
withdrawals to pay college expenses for themselves, a spouse,
children, or grandchildren.
1This example is hypothetical in nature and is not
indicative of future performance in your retirement plans.
© 2011 McGraw-Hill Financial Communications. All rights
reserved.
