What is an Individual Retirement Account (IRA)?
IRA stands for "Individual Retirement Account." It is a savings account to put money away for retirement, but it can only be used under certain circumstances. People decide to use this form of saving mainly because of the tax benefits it provides.
There are three different types of IRAs: (1) traditional IRAs, (2) Roth IRAs, and (3) SIMPLE IRAs.
Traditional IRAs are the accounts that have been around the longest. (That is why these accounts are called "traditional".) An individual can contribute up to $5,000 per year (or $6,000 if older than 50), if he or she has income of at least $5,000 (or if the spouse has income of at least $5,000) and if he or she is not covered by a retirement plan at work, or if covered by a retirement plan has less than a specified income. You can contribute until you reach the age of 70 1/2 at the end of a tax year. When you make a contribution from your income, the contributed amount is not subject to income tax now — so you deduct that from your taxable income, which reduces the taxes you pay in that year. It is only when the account owner withdraws money during retirement that taxes will be due on the earnings of the assets, but not on the assets themselves. So, the benefit is that only the return on IRA assets is subject to tax, and then only when (at retirement age) you withdraw the money. The drawback is that if you use the money held in an IRA account before retirement, you may have to pay a penalty in addition to taxes.
Contributions to Roth IRAs have basically the same limitations as traditional IRAs with the two major differences. First, contributions cannot be deducted from taxes. Second, there is no age limit for contributions. The tax advantage of Roth IRAs will be enjoyed when the account holder, after retirement, withdraws money from a Roth IRA; all assets held in a Roth IRA can be withdrawn tax-free during retirement. Contributions to a Roth IRA make the most sense if the current tax rate is lower than the one projected during retirement — this situation can safely be assured to work for almost all very young employees. However, chances are that taxes will be higher for all income levels in the future, which is why Roth IRAs do not make a lot of sense for most individuals.
A SIMPLE IRA is a retirement plan that small employers set up for their staff. "SIMPLE" stands for "savings incentive match plans for employees" in this case. Such a retirement is easy to set up and to administer, which is why it is mostly used by small business owners. Employees have to be notified about the details of such a plan by their employers. That's why I cannot generalize about them here.
Once again, IRA account holders are generally not permitted to withdraw money until retirement except for a few "hardship" conditions. Any withdrawals except for such conditions may be subject to taxes and penalties. Some accounts also have certain withdrawal requirements during retirement.
As with all matters concerning taxes, it is best to discuss IRAs with a tax professional who can take one's own particular circumstances into consideration. More information is available at the IRA page maintained by the IRS (Internal Revenue Service).
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