| Topic - IRA Essentials | Education Center |
An IRA, or Individual Retirement Account, is a special account that you establish with a bank, mutual fund company, or brokerage in which you can save funds for retirement.
One tax-cutting benefit of an IRA makes it particularly appealing to many investors. If your modified adjusted gross income (MAGI, the amount of your annual income that the IRS uses to determine the taxes you owe) is below a certain level, then you can deduct your IRA contributions from the amount of your income that's subject to federal income taxes. That lowers your tax bill.
If you're covered by a retirement plan -- such as a 401(k) -- at work, the amount that you are allowed to put into your IRA is determined by your MAGI. If your MAGI in 2000 is less than $32,000 for a single taxpayer or $52,000 for a married couple filing jointly, you can deposit up to $2,000 (each, if married) as a deductible contribution. The amount that can be contributed and deducted is scaled down for single people who make up to $42,000 and for couples who earn up to $62,000.
If you're not covered by a retirement plan at work, you can deduct your entire IRA contribution, regardless of your income. (If your employer offers a plan but you do not contribute to it, you might still be considered an active participant. Be sure to check with your employer.)
If you're not eligible to make a deductible contribution to an IRA, it is possible to contribute to a "non-deductible IRA." Non-deductible contributions still grow tax-deferred in the IRA, but withdrawals after the age of 59 ½ are taxable only on the gains in the portfolio -- you already paid the taxes on the original contributions. In a fully-deductible IRA, contributions and earnings are entirely taxable because 100 percent of the original contributions provided a tax deduction to the individual.
The main advantage of an IRA is that you pay no taxes on gains in the account until you retire. This is why IRAs are referred to as "tax-deferred" accounts -- taxes on dividends, interest, and capital gains are all deferred until retirement. When you eventually do retire, you can begin to withdraw money from the account and use it to augment your income from Social Security and other retirement plans. At that time, you'll pay taxes on the funds you take out at the IRS's "regular income" tax rate.
One warning about IRA withdrawals: Generally, if you take out funds from your IRA before the age of 59½, you'll pay a penalty. One change in the Taxpayer Relief Act of 1997 now allows withdrawals from a regular IRA without penalty for the following reasons:
There are lots of complicated rules about IRA accounts, but the bottom line is that by letting your funds grow tax-free over a long period, you can build a substantial nest egg for your retirement. IRAs are designed to help you plan for a comfortable retirement, however. You should remember that they lose their benefits if you tap into the account too soon.