Individual Retirement Accounts

What is an IRA?

Like most people who haven't begun to plan for their retirement, you're probably wondering what is an individual retirement account? An IRA is like a trust or custodial account. There is a trustee or custodian that looks over your funds, such as a bank, mutual fund, savings institution, etc. The trustee invests your money according to the plan that you have selected.

Self-directed IRAs

A self-directed IRA is established by the investor who wants to have more of a say in his/her investments. In this type of account, you can make your own investment decisions, with the trustee or custodian simply handling and managing your account. The fees on self-directed IRAs, as a result, are very high. It would not make sense to open a self-directed IRA until you have built up a large IRA fund and have considerable experience in investing. In these types of funds, the investor is prohibited from investing in all collectibles, with the exception of US minted coins of one ounce or less.

IRA Annuities

An IRA annuity is a contract or an endowment that is issued by an insurance company which pays a specified amount monthly beginning at age 59½, or at your retirement. This payment continues for life. There is no required custodian or trustee needed to structure such an annuity. In fact, you can get the terms of the annuity configured in such a way that the contract is on your life, or a joint and survivor contract with you and your spouse. The annuity that the insurance company pays simply has to meet the terms of an IRA that you own. There are some limitations on this contract, however. No deduction is permitted for the portion of the premium allocable to life insurance. This nondeductible amount is referred to as a P.S. 58 and will be supplied by the insurance agent that you deal with. In addition, there are no loan provisions on these annuity contracts because borrowing or pledging of the contract is not allowed under an IRA. One last note of caution when setting up an IRA annuity: There are steep insurance company fees initially, so determine how much of the charges you are paying are for the purchase of the annuity itself and how much is for the insurance company.

IRA Break-even Point for Young Workers

The way that IRAs are structured, an investor is not allowed to deduct money from the account before the age of 59½, without incurring a 10% penalty on top of regular taxes on the amount that they deduct. In a sense, this money, even though it is your money, is frozen in the IRA until that age. Thus, it would not make sense for the young investor who has major expenses such as college, home, etc. to worry about, to tie up his/her funds in an IRA. The break-even point for the typical investor when dealing with IRAs varies considerably, especially due the specifics of the IRA account that you have, and the tax bracket that you are in. In general, the break-even point is longer for younger people than it is for older ones. If your IRA earns a 10% interest rate and you are in the 28% tax bracket, you will break-even on your investment into the IRA in about 10 years. A person who is older than 59½, however, starts to come out ahead on his/her IRA after only one year, because he/she does not have to worry about penalties on withdrawing money. It sounds complicated, and it is, so there is no need to rush into anything.

IRA Contribution Limits

You are allowed to invest up to $2,000 into your IRA every year if you earn that much, or all of your income if it is less than that. You may invest less than that, based on your discretion. If you are married and both of you work, then the maximum total contribution allowed is $4,000. Depending on your overall financial picture, it may make sense for you to vary the amount that you invest each year into your IRA. Also, you can only contribute money to an IRA from earned income from personal services, salary, wages, tips, commissions, bonuses, etc. Investment income is specifically disallowed from being contributed to an IRA.

IRA Deductions

It is also important to know your IRA deductions. IRA contributions vary from completely deductible, to partially deductible to not deductible at all. This can become messy, so we will tell of the two instances when your contributions are 100% deductible: 1. Your adjusted gross income (AGI) is less than $25,000 if you are single or the head of the household. Your adjusted gross income (AGI) is less than $40,000 if you are married filing a joint return. 2. You are not covered by any employer retirement plan. In this instance it does not matter what your AGI is. For the people whose incomes exceed the amounts stated above and are in a company retirement plan, the contributions to an IRA are subject to deduction phaseout. The deduction is reduced over the next $10,000 of AGI. In other words, the AGI range for phaseout of IRA deduction is $25,000- 35,000 for a single person or head of a household, and $40,000-50,000 for a couple fling jointly.

Age Limit on Contributions

There is no minimum age requirement to make contributions to an IRA. Children who have earnings can contribute to this fund, but should be aware that this money will not be accessible to them until age 59½, at least without penalty. At the other end, you cannot contribute to your IRA in the year that you reach the age of 70½. Also, once you reach age 70½, you have to start taking distributions (withdrawals) from your IRA by April 1 of the following year.

When to Contribute to Your IRA

A contribution for 1996 may be made any time during 1996, but no later than April 15, 1997. Also, you cannot make contributions to your IRA before the start of the year. Your 1997 contribution cannot be made prior to January 1, 1997. As we mentioned earlier, you do not have to make all of your contributions at once. You will earn different interest if you contribute money at different times of year. You will earn the prevailing interest, depending on whatever the going rate is. If you have the cash to do so, it is advised by many to invest as much as possible into your IRA at the beginning of the year because earnings will accumulate tax free.

Penalties

There is a penalty for contributing too much to your IRA. If you contribute more than is allowed, whether as a deductible or nondeductible contribution, the excess amount is subject to a 6% penalty. The penalty tax is cumulative, as well. You will be subject to another penalty in the following year on the excess contribution. So just be careful! Also, as we mentioned earlier, there is a penalty of 10% on premature distributions made from your IRA. An exception is if you are disabled and need the money in your IRA. In this case, there is no 10% penalty.

What happens after age 70½?

You are required to start taking distributions from your IRA the calendar year in which you reach age 70½. The IRS publishes life expectancy figures in their annuity tables. The full tables can be found in the IRS Publication 575. You must withdraw a particular amount according to this table. The minimum distribution is refigured every year according to your life expectancy. This can prove to be an advantage if you want to take smaller distributions and conserve the principal that you had invested originally. This whole process continues until, obviously, the IRA is exhausted.