Not to be confused with your great-uncle Ira, an IRA is simply a personal retirement savings account with a special set of deposit and withdrawal rules. IRA stands for “Individual Retirement Account” and it comes in several varieties; the most common is a “Traditional IRA” which means that deposits are made on a pre-tax basis. Said another way, a Traditional IRA has income taxes deferred until a withdrawal is made in retirement, which is often an investment and income tax advantage for the account holder.
In contrast to an employer retirement plan like a 401(k) where there are many workers who participate, the IRA is individualized – a single account for the individual worker. This gives the IRA account holder a far greater variety of investment choices and much more control over how the account is managed, unlike most employer plans that have a small menu of investment choices that the worker had zero input in selecting.
IRA Deposit Rules
IRAs have special deposit rules. To make a deposit to a Traditional IRA, a worker must have earned income (wages) in the year the deposit is made. Retirees or those who are not employed cannot contribute to a Traditional IRA. There is an exception for stay-at-home parents, but the parent at home must be married and the working spouse must have wage income.
Deposits are limited to the lesser of $5,500 or wages earned per worker per year if the worker is age 49 or younger. If the worker is age 50 or older, deposits are limited to the lesser of $6,500 or wages earned per worker per year. For example: David, a 24-year-old part-time dog groomer who earned $3,500 in 2018 may contribute $3,500 to an IRA in 2018. Lisa, a 53-year-old receptionist who earned $45,000 in 2018 may contribute $6,500 to an IRA in 2018.
Income Tax Benefits
IRAs also have special income tax benefits. First, income taxes are deferred until the worker takes withdrawals from the IRA in retirement. This means that the account investments can grow in value over the worker’s career and the IRA account holder won’t owe any taxes until retirement. The younger the worker with an IRA is, the greater the benefit/the longer the account can grow without paying income taxes. Second, if your employer does not offer an employee retirement savings plan such as a 401(k), you may be eligible for an income tax deduction if you contribute to an IRA. Income limits apply; consult your tax preparer for more information regarding this deduction and if you qualify.
Finally, IRAs have special withdrawal rules. An IRA account holder must be at least age 59 ½ to make a withdrawal; if a withdrawal is taken before reaching age 59 ½, a penalty tax of 10% applies unless the worker meets one of a limited number of exceptions. Withdrawals are counted as ordinary income to the IRA account holder in the year the withdrawal is taken (taxable just like wage income) and are reported on tax form 1099-R at the end of the year.