Individual Retirement Accounts and Individual Retirement Annuities (IRAs) are special retirement plans primarily for individuals who work for themselves. There are three types, a traditional IRA, a Roth IRA, and a non-deductible IRA. (There is also an "educational IRA", which is really an education savings account and is not discussed here.) Anyone with "earned income" can qualify for at least one of the types. All three allow for tax-free growth, but deductibility of contributions and taxation of distributions vary among the three types.
Generally, contribution limits for all three types are the greater of earned income or $2000 per year. There are two exceptions. First, up to $2,000 can be contributed for your spouse even if he or she does not earn income. Second, some employers set up "Simplified Employee Plan" (SEP) IRAs, or Savings Incentive Match Plan for Employees (SIMPLE) IRAs that use IRAs for each employee. Employees may contribute amounts greater than $2,000 to these IRAs.
Opening an IRA is easy, and most banks or brokerages will be glad to help you. Many of the rules however, are quite complex, and consulting with an expert would be a good idea. In fact, if you are considering withdrawing money from an IRA, a consultation is strongly recommended.
Traditional IRA
Anyone who is not covered by another type of retirement plan can contribute to a traditional IRA. Contributions of up to $2,000 per year are taken as a deduction from your income. The account is not taxed until you take money ("distributions") from the IRA. These distributions are all taxed as ordinary income. You may begin to take distributions when you reach 59½, and you must begin taking distributions after you turn 70½.
If you are covered by another retirement plan, you may not be allowed to contribute to a traditional IRA. If you earn more than $33,000 ($53,000 for married couple filing a joint return) in 2001, the amount you can contribute will be reduced. If you earn more than $43,000 ($63,000 for married couple filing a joint return), you will not be able to contribute this year to a traditional IRA.
The limit is much higher if your working spouse is covered by a retirement plan. He or she can earn up to $150,000 without affecting your ability to make IRA contributions in 2001.
Roth IRA
A Roth IRA is different from a traditional IRA. Instead of deductible contributions and taxable distributions, a Roth IRA has non-deductible contributions, but no tax on distributions. This means that once you put money into a Roth IRA, it will ordinarily never be taxed again. Like the traditional IRA, you can begin receiving distributions at age 59½. However, you are not required to take distributions during your lifetime.
There are income limits on a Roth IRA. If you are single, the allowable contribution is reduced for annual incomes above $95,000, and disallowed for incomes over $110,000. If you are married and file a joint tax return, your limits are $150,000 and $160,000. If you are married but file separate returns, your limits are $0 and $10,000.
Can I convert a traditional IRA to a Roth IRA?
Sometimes, but there is a price to pay if you do. Your income in the year you convert must be less than $100,000 (married or single), and you must pay tax on all that you convert. If you do that, you will have converted to a Roth IRA, with its advantages.
Because of the tax to be paid, it is not always a good idea to convert to a Roth IRA. Generally speaking, the closer you are to a retirement age, the less likely that a conversion will be the right move. This is an area where you may want to talk to an expert.
Nondeductible IRA
If you have earned income but do not qualify for either a traditional IRA or a Roth IRA, you can still contribute to a nondeductible IRA. Actually, a nondeductible IRA is simply a traditional IRA in which some or all of the contribution cannot be deducted. An example would be if you are covered by another retirement plan and had too much income to make a deductible contribution to your IRA. You could still contribute up to $2,000 as a nondeductible contribution.
Why would you want to do so? Because of the tax-free growth. Also, only the growth will be taxed when you take distributions. The money you put in will not be taxed when you take it back out.
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