A little bit of knowledge and planning can go a long way toward helping you build a nest egg for your retirement. One great way to start building that nest egg is with an IRA -- a tax-advantaged savings plan to help you get ready for the day you stop working.
While it may seem overwhelming at first, there are only a few basic things you need to know to make IRAs work for you. Read on for what you need to know about IRA accounts, including eligibility, contribution limits, types, providers, and minimum distributions.
IRA account: What is it?
The IRA, while commonly referred to as an individual retirement account, actually stands for individual retirement arrangement. It's a personal savings account that gives tax advantages to those planning for retirement. Contributions withdrawn before the owner reaches age 59-1/2 generally incur a 10% penalty on the distribution, as well any other taxes owed. There are some exceptions, however. If you need the money to cover various hardships, you won't owe the penalty (read more here). A person can also withdraw $10,000 penalty-free if the money is used for a down payment on a first home.
IRA vs. 401(k)
Generally speaking, anyone with earned income can open an IRA, but you can only open a 401(k) account through your employer. There are significant advantages to a 401(k) over an IRA, the biggest of which is the possibility (though not guarantee) of an employer match of 401(k) contributions. The yearly contribution limits are also much higher for 401(k) accounts than for IRAs. Best of all, you can have multiple retirement accounts -- for example, both a 401(k) and an IRA -- so you can take advantage of all the different tax-advantaged savings opportunities the government allows.
Traditional IRA vs. Roth IRA
There are two types of IRA accounts: traditional IRAs and Roth IRAs. Both allow your investments to grow tax-free. The difference is when you pay taxes on your contributions.
Contributions to traditional IRAs can be tax-deductible depending on your income level and whether you have a retirement plan through work. Withdrawals from traditional IRAs are taxed as regular income.
Contributions to Roth IRAs are never tax-deductible. However, the benefit of Roth IRAs is that withdrawals are tax-free after the age of 59-1/2.
The other difference is that traditional IRAs require you to withdraw a certain amount each year once you turn 70-1/2, but Roth IRAs have no required minimum distributions. If you are over age 70-1/2, the IRS provides a great guide, along with worksheets to help you calculate your RMD.
IRA account eligibility and deductibility
You must be younger than 70-1/2 to open a traditional IRA, but you can start a Roth IRA account at any age. Depending on your income, filing status, and whether you're covered by a retirement plan at work, contributions to a traditional IRA account may or may not be tax-deductible. If you do have a retirement plan at work, then your deduction limits are as follows:
Here's the breakdown if you don't have a retirement plan at work.
IRA account contribution limits
For tax year 2014, the government allows contributions of up to $5,500 in an IRA. Those aged 50 and over can contribute an additional $1,000 as a catch-up contribution. Note that if your taxable income is below $5,500, your maximum contribution is your level of taxable income; IRAs must be funded with earned income.
For a Roth IRA, contribution limits begin to drop as income rises past a certain level before being phased out completely:
If your income falls in the reduced-amount areas, you can check out the full calculations for determining how much you can contribute to a Roth IRA.
IRA account providers
There are many IRA providers. As with most things in investing, lower fees are better than higher ones for basic products such as IRAs. You can compare IRA account providers here.
IRA accounts are one of the best tax-advantaged ways to save for retirement. If you have more questions on IRAs, check out The Motley Fool's IRA Center.