Individual Retirement Accounts

An Invidual Retirement Account is a savings account

© Ryan McVay / Getty Images

Individual Retirement Accounts, or IRAs, are basically savings plans with lots of restrictions. The main advantage of an IRA is that you defer paying taxes on the earnings and growth of your savings until you actually withdraw the money. The main disadvantage is the tax law imposes penalties if you withdraw the funds before you turn age 59.5 years old. There are different types of IRAs, each with their own tax implications and eligibility requirements.

Traditional Individual Retirement Accounts

The key features of a traditional IRA:

  • You get a tax deduction for the savings you contribute to the account. This deduction reduces your taxable income, so you are basically not paying income tax on the money you set aside in a Traditional IRA.
  • The savings grow tax-deferred, which means you won't have to include interest, dividends, or capital gains from the IRA in your annual income.
  • When you withdraw the money, the distribution from the IRA is included in your taxable income. It is taxed as ordinary income.
  • If you withdraw the money before reaching age 59 and a half, there is an additional 10% tax on that early distribution.
  • You must begin withdrawing money from a traditional IRA beginning with the year when you turn age 70.5 years old. You must take at least the required minimum distribution each year, or else pay an excise tax of 50% of the required minimum distribution amount.

    There are restrictions on who can take a deduction for Traditional IRA contributions. If you or your spouse are covered by a retirement plan at work, your deduction may be limited or you might not be able to deduct any of your contribution.

    Nondeductible Traditional Individual Retirement Accounts

    A nondeductible IRA is a traditional IRA.

    However, the contributions are not tax-deductible.

    • The savings grow tax-deferred.
    • When you start taking distributions, part of the distribution will be a tax-free return of your original, nondeductible contribution, and the rest will be taxed as ordinary income.

    People usually opt for a nondeductible IRA when they find themselves in a very specific financial situation: when they are covered by a retirement plan through their employer, and their income is too high to be eligible to deduct their traditional IRA contributions, and they are not eligible to fund a Roth IRA, and they want to contribute extra savings towards retirement in a tax-deferred account.

    The primary difference between a nondeductible IRA and a traditional IRA is the tax treatment of the original contribution. Since nondeductible IRAs are traditional IRAs, all the other rules that apply to traditional IRAs also apply to nondeductible IRAs. Namely, there's a 10% surtax on early distributions, and distributions need to begin in the year the accountholder turns age 70.5 years old.

    Roth Individual Retirement Accounts

    A Roth IRA provides potentially tax-free savings and distributions. Unlike a traditional IRA, you don't get a deduction for your contributions.

    That makes them similar to nondeductible IRAs. But there are significant differences in how the distributions are taxed.

    The key features of a Roth IRA:

    • Contributions are not tax-deductible.
    • The savings grow inside of the Roth IRA without needing to pay any taxes on the earnings and growth.
    • Distributions from a Roth IRA are completely tax-free, as long as you meet certain conditions.
    • You can contribute to a Roth IRA even if you are covered by a retirement plan at work.
    • Roth IRAs do have income limitations.
    • The required minimum distribution rules do not apply to Roth IRAs.

    IRA Contribution Limits

    The total amount that can be contributed to a traditional IRA or a Roth IRA (or any combination of the two) is limited.

    • For 2016, the maximum IRA contribution is $5,500.
    • For 2015, the maximum IRA contribution is $5,500.
    • For 2014, the maximum IRA contribution is $5,500.
    • If you are age 50 or older, you can contribute up an additional $1,000, which is called a catch-up contribution. (This amount does not change each year.)

    The contribution limit applies across traditional, nondeductible, and Roth IRA types. So if you wanted to fund both a traditional IRA and a Roth IRA, you could contribute any combination of funds to each IRA type, so long as the total does not exceed the annual limit. For example, a person could put $2,750 into a traditional IRA and another $2,750 into a Roth IRA.

    IRA contributions are also limited by your qualifying income. For IRA purposes only, qualifying income means wages, self-employment income, alimony, and nontaxable combat pay. For example, let's say you have wages of $3,500 and no other income. Your can contribute up to $3,500 in any combination of traditional, nondeductible, or Roth IRA for the year.

    Simplified Employee Pension Individual Retirement Accounts

    SEP IRAs are a type of group retirement plan. An employer establishes a SEP IRA plan, and then makes contributions to a traditional IRA set up inside of the SEP IRA plan. SEP IRAs are popular with self-employed people, because SEP IRAs allow for higher contribution limits than a regular IRA. Otherwise, SEP IRAs are treated similarly to traditional IRAs. Contributions are made with pre-tax dollars, distributions are taxed as ordinary income, and there are penalties for taking an early distribution.

    Savings Incentive Match Plans for Employees

    SIMPLE IRAs are also a group retirement plan. They are easier to set up and maintain than 401(k) or pension plans, but they offer lower contribution limits than other group plans. SIMPLE IRAs allow for pre-tax dollars to be contributed, with matching from the employer. Distributions are taxed as ordinary income, and there are penalties for early distributions.

    When Contributions Must be Made

    You can contribute funds to an IRA at any time throughout the year. After the year has ended, you can still make a contribution towards the previous year's IRA, as long as the contribution is made by the April deadline.

    For tax year 2015, the deadline for funding IRAs is April 18, 2016.