Traditional IRA

What is an IRA

Congress established the traditional IRA (Individual Retirement Account) in 1974 as part of the Employee Retirement Income Security Act (ERISA). The traditional IRA was initially available only to those workers who did not have access to employer-sponsored retirement savings plans. However, in 1981, the Economic Recovery Tax Act made IRAs available to all workers under the age of 70 ½. Since then, Congress has made several other changes to the rules and regulations that govern IRAs. But the original principle – allowing workers a tax-deferred method of saving for retirement – remains in place.

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A traditional IRA is a tax-qualified account. Tax-qualified means that the account meets the requirements established by Congress that allow taxes on the contributions and the earnings to be deferred until a later point in time. For example, if you are single, under the age of 50, and earn $65,000 in 2011, you can contribute up to $5,000 to a traditional IRA. The $5,000 will not be included in your taxable income for the year and taxes will not be deducted from earnings for as long as they remain within the account. It's important to understand that a traditional IRA is a tax-deferred account, not a tax-exempt account.

Where to Invest an IRA

An IRA must be kept with a qualified custodian. The custodian is responsible for maintaining records on the account, such as contributions received, earnings credited, and distributions made. The custodian can be a bank, a savings and loan, a brokerage house, or any financial services company that meets the qualifications as established by Congress and the Internal Revenue Service.

A bank is often a good place to keep at least part of your IRA, especially if you're averse to risk, or if you're nearing retirement. Banks offer low-risk financial instruments such as Certificates of Deposit. While the return may not be that of other investments such as stocks or bonds, CDs offer a way to ensure that the money is safe because they are FDIC insured.

Over the past 15 years or so, especially since the rise of online discount brokerages, competition for self-directed IRA accounts has become increasingly intense. These days, most custodians don't charge the account owner to open an IRA. And, if annual management fees are charged, they are usually nominal. Like banks, brokerage houses make money by lending money to other account holders. But they also make money on the trades that occur within the account. In other words, even if you don't pay a management fee on the IRA, you'll still pay a per transaction fee to buy and sell stocks within the account.

IRA Eligibility Requirements

In order to contribute to an IRA, an account owner must have earned income and must be younger than age 70 ½. The maximum amount that can be contributed to an IRA and deducted from your taxes for 2011 depends on your age, modified adjusted gross income and whether or not you make contributions to an employer-sponsored retirement savings plan, known as a defined-contribution plan.

The maximum amount that can be contributed by someone under the age of 50 is the lesser of $5,000 or the amount of taxable compensation. For those over the age of 50 by the end of 2011, the limit is the lesser of $6,000 or the amount of taxable compensation. (The Economic Growth and Tax Relief Reconciliation Act of 2001 allowed those over 50 to contribute an additional amount known as the "catch-up" contribution.)

If you are married and your spouse does not work outside the home and therefore does not have earned income, you can establish a spousal IRA, subject to the same contribution limits above.

Single, head of household, and qualifying widows and widowers with a modified adjusted gross income of any amount can fully deduct IRA contributions. Those who are married and file jointly or separately can also fully deduct IRA contributions regardless of the amount of modified adjusted gross income, as long as the spouse is not covered by an employer-sponsored retirement savings plan.

Those who are married and file jointly with a spouse who is covered by an employer-sponsored plan can fully deduct contributions if the modified adjusted gross income is $167,000 or less. If the modified adjusted gross income is more than $167,000 but less than $177,000, a partial deduction is allowed. For those whose modified adjusted gross income is more than $177,000, no deduction is allowed. Finally, for those who are married and file separately but have a spouse who is covered by a work plan, there is no deduction if the modified adjusted gross income is more than $10,000.

Traditional Individual Retirement Account Distributions

It's important to note that IRAowners always have access to both the contributions they've made and the earnings that have accumulated. However, distributions made prior to the age of 59 ½ are subject to what is known as the "Age 59 ½ Rule." This rule states that with few exceptions, a 10% tax on the amount of the distribution will be assessed. In addition, the early distribution must be declared as income for the year.

There are exceptions to the Age 59 ½ rule. An account owner under the age of 59 ½ can receive early distributions penalty-free under the following circumstances:

  • He or she has un-reimbursed medical expenses greater that 7.5% of his or her adjusted gross income
  • The distributions are used to pay for medical insurance following unemployment for at least 12 weeks
  • The account owner becomes permanently disabled
  • The IRA is inherited due to the death of the account owner
  • The distributions are used to pay for qualified education expenses for the account owner, his or her spouse, child or grandchild
  • The money is used to buy (or build or rebuild) a first home
  • It is used to pay an IRS levy

Regardless of the circumstances, traditional IRA account owners are always advised to seek the advice of a qualified financial advisor prior to taking an early distribution.

Distributions from an IRA must begin by April 1 of the year following the year in which the account owner reaches 70 ½. For example, the owner of an IRA whose 70th birthday is June 1, 2010, will turn 70 ½ on December 1, 2010. He or she must then begin receiving distributions from the account by April 1, 2011.

While we've covered the basics of IRA investing here, there is much more to maximizing the success of you IRA. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.

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