All About IRAs

What IS an IRA?

All About IRAs
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By Dave Braze

What is an IRA, anyhow? An Individual Retirement Arrangement (IRA), commonly called an Individual Retirement Account, is a personal retirement savings plan available to anyone who receives taxable compensation during the year. For IRA contribution purposes, compensation includes wages, salaries, fees, tips, bonuses, commissions, taxable alimony, and separate maintenance payments.

Husbands and wives may each have an IRA, even if one person in that marriage is not working. One person's annual contribution, whether made to just one or to multiple IRAs, is limited to the lesser of total taxable compensation or to the normal yearly amount shown in the following table. Persons age 50 or older may make an additional catch-up contribution in the amount indicated in the table below.

Traditional and Roth IRA Annual Contribution Limits
Year Normal Catch-up
2001 $2,000 $0
2002 $3,000 $500
2003 $3,000 $500
2004 $3,000 $500
2005 $4,000 $500
2006 $4,000 $1,000
2007 $4,000 $1,000
2008 $5,000 $1,000
2009+ Indexed* $1,000
*Normal contribution limits will increase annually by $500 whenever cumulative inflation exceeds the next higher $500 increment.

There is no minimum or required IRA contribution, and all earnings on the amounts in an IRA are untaxed until withdrawn. In the case of the Roth IRA, withdrawals may even be tax-free provided certain minimum rules discussed later are met.

Contributions to a Roth IRA are never tax-deductible. Contributions to a traditional IRA may or may not be deductible in the tax year made, depending on the owner's income tax filing status, adjusted gross income (AGI), and eligibility to participate in a tax-qualified retirement plan through employment. If the traditional IRA owner participates in an employer's qualified retirement plan on any day in the tax year, the deductibility of contributions declines to zero between certain AGI ranges as shown in the following table.

AGI Phase-Out Limits for Deductible Traditional IRA
Year Single Filer Joint Filer
2001 $33,000 - $43,000 $53,000 - $63,000
2002 $34,000 - $44,000 $54,000 - $64,000
2003 $40,000 - $50,000 $60,000 - $70,000
2004 $45,000 - $55,000 $65,000 - $75,000
2005 $50,000 - $60,000 $70,000 - $80,000
2006 $50,000 - $60,000 $75,000 - $85,000
2007* $50,000 - $60,000 $80,000 - $100,000
*2007 and later

A working spouse not covered by a retirement plan through employment may make a tax-deductible contribution of up to $2,000 annually to an IRA despite the other spouse's coverage under an employer-provided retirement plan. When the couple's AGI reaches $150,000, deductibility for such contributions begins to decline, and it reaches zero at a joint AGI of $160,000.

Money may be withdrawn from an IRA at any time, but on withdrawal it may be taxed and/or penalized. Withdrawals from a traditional IRA will always be taxed, either in whole or in part, at ordinary income tax rates. Except as noted below, withdrawals from a traditional IRA prior to age 59 1/2 will result in a 10% excise tax as well as an ordinary income tax. The potential income taxes and early withdrawal penalties on Roth and Education IRA withdrawals will be discussed in subsequent articles.

If nondeductible contributions were made to a traditional IRA, part of any withdrawal from that IRA will not be taxed. The calculations for deriving the taxable and nontaxable part of the withdrawal are too complicated to cover here. For those who may face this problem, the IRS has a handy-dandy way to make that calculation. It's called Form 8606, a tax document that must be completed and filed with your income tax return to report both nondeductible traditional IRA contributions and withdrawals whenever they occur.

Mandatory distributions for traditional IRAs must begin no later than April 1 of the year following the year the IRA owner reaches age 70 1/2. Failure to take required minimum distributions at that age results in a 50% excise tax on the amounts not distributed. Roth IRAs have no mandatory distribution requirement, but Education IRAs do as discussed here.

There are eight exceptions to the 10% penalty for IRA withdrawals prior to age 59 1/2. The early withdrawal penalty does not apply to distributions that:

  1. Occur because of the IRA owner's disability.
  2. Occur because of the IRA owner's death.
  3. Are a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner.
  4. Are used to pay for unreimbursed medical expenses that exceed 7 1/2% of adjusted gross income (AGI).
  5. Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.
  6. Are used to pay the costs of a first-time home purchase (subject to a lifetime limit of $10,000).
  7. Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members.
  8. Are used to pay back taxes because of an Internal Revenue Service levy placed against the IRA.

Except as noted in later discussions on Roth and Education IRA distributions, ordinary income taxes are still due and payable on IRA withdrawals taken under any of the above exceptions.

So how many kinds of IRAs are there, anyhow? Would you believe ... 11?

Next: The Eleven Types »« Previous