Saving for retirement is essential for your long-term financial security, and individual retirement accounts can help you take advantage of tax-saving opportunities with your retirement assets. IRAs are easy to open, and can get you on the path toward retirement security quickly and simply; but there are some rules that you have to keep in mind when considering an IRA. Below, we'll look at three of the most-important rules governing IRAs, with a brief explanation to bring you up to date about what you need to know.
Rule 1: To contribute to an IRA, you need to have compensation income.
Most people understand that there are dollar limits to the amount that you can contribute to an IRA. For 2016, those limits are $5,500 for those younger than age 50, and $6,500 for those 50 or older. However, what some people don't know is that you can't contribute to an IRA at all if you don't have what the IRS considers to be income in the form of compensation. If your compensation is less than the limits above, you can only contribute the amount of your compensation.
Specifically, the IRS considers wages, salaries, commissions, and self-employment income to be included within the definition of compensation. In addition, compensation includes any taxable alimony and separate maintenance payments you receive under legal decrees. It also includes nontaxable combat pay for members of the U.S. Armed Forces.
However, compensation does not include several other types of income. Rental income, interest, and dividends don't count, nor do pension and annuity income. Deferred compensation from past years is not allowed to be the basis for an IRA contribution, and passive partnership income isn't permitted if you don't provide services that are material to producing income for the partnership. With the exception of qualified combat pay, nontaxable earnings don't generally count as compensation.
Rule 2: There are big differences between traditional and Roth IRAs.
There are two main types of IRAs: traditional and Roth. Traditional IRAs allow you to claim a tax deduction for your contributions, but the withdrawals you make in retirement are taxed as ordinary income on your tax return. Roth IRAs don't give you a contribution deduction, but qualified withdrawals in retirement are tax free.
Income limits apply to when traditional IRA contributions are deductible, and different income thresholds can disallow Roth IRA contributions entirely. Traditional IRAs also require that you take minimum distributions once you reach age 70-1/2, while Roth IRAs have no required minimum distribution at all.
As a guideline, Roth IRAs tend to be more attractive to those currently in low tax brackets, while traditional IRAs look better to those in high tax brackets. However, generalizing can be a mistake, and every particular situation requires close examination to determine which type of IRA is the best.
Rule 3: Don't make mistakes moving your IRA money around.
One pitfall that many retirement savers fall into happens when it comes time to move their IRA money to a new account. The safest way to move money from one IRA to another is by what's called a direct transfer, where the two financial institutions move the money directly without it ever coming into your hands.
The slightly riskier method of moving IRA money is known as a rollover. With this method, your current financial institution sends a check to you with your IRA money, and you then have 60 days to deposit that money with your new financial institution. If you do so, the move is treated as a tax-free rollover. However, a couple of complications often occur with rollovers.
First, your current financial institution will often withhold taxes from the check it sends you. If you don't redeposit the full amount -- including what the company withheld -- then the part you didn't redeposit will be treated as taxable, and come with penalties if you're not yet age 59-1/2, and don't qualify for an exception.
The other challenge is that you're only allowed to do one rollover every 12 months. Try it more often, and the subsequent rollover will be treated as taxable -- even if you redeposit it within the 60-day time period.
IRAs can be extremely useful ways to save for retirement. But you have to make sure you follow the rules. By keeping these and other IRA rules in mind, you'll be able to use these tax-favored retirement accounts to maximum advantage.