How Does an IRA Work?

December 4, 2014

how does an IRA workIf you haven’t started considering your retirement plan yet, it is not too late to start.  Though Social Security provides some retirement income, most of us are hoping for a more comfortable retirement than those limited funds can provide.  An IRA is a wonderful investment tool that will allow you to plan, save and invest in your future, while creating valuable tax breaks.  So, how does an IRA work?  It is not as complicated as you might think.
What is an IRA?
First, an IRA is simply a tax-deferred savings plan.  IRA stands for Individual Retirement Account, and it is established in compliance with the IRS guidelines.  There are four specific types of IRAs, each with its own benefits.  The first two (Traditional IRAs and Roth IRAs) are created by individuals. Both a Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are made available through an employer. All IRAs are “fully vested,” meaning that all contributions and earnings belong to the individual, including those contributions made by their employers.
The different tax implications
There are significant differences between the ROTH IRA and the other types of IRAs based on when the funds are taxed and when the funds can be withdrawn without penalty.  Contributions made to a Traditional IRA are deducted from gross income for income tax purposes and any investment earnings are not taxed as long as they remain in the IRA account.  When you reach age 59 ½, you are allowed to withdraw from the IRA account, without penalty.  When you withdraw funds from the Traditional IRA upon retirement, the money is then taxed as ordinary income. A SEP IRA and the SIMPLE IRA, which both involve employer contributions, provide the same tax advantages as a Traditional IRA.
On the other hand, when cash is placed into a Roth IRA account, it is considered “after-tax,” meaning that you are not allowed to deduct your contributions.  But, when you reach the retirement age of 59 ½, all of the funds are distributed to you tax free.
Limitations on Contribution Amounts
The IRS has placed limitations on the total amount of contributions you can make to your IRA account.  These limits often change from one year to the next, so consult with your accountant or Retirement Planning Attorney to determine the limitations that currently apply.  In 2014, the total contributions you can make to your Traditional and Roth IRAs can be no more than $5,500. If you are age 50 or older, the limit is $6,500. However, if your taxable compensation for this year is less than that amount, then your limit is the amount of your taxable compensation.  The contribution limits for an SEP and SIMPLE IRA are higher. The total amount an employee can contribute to a SIMPLE IRA cannot exceed $12,000 in 2014 and $12,500 in 2015. The maximum contributions for an SEP in 2014 is $52,000 and $53,000 in 2015.
If you have questions regarding IRAs, or any other retirement planning needs, please contact Anderson, Dorn & Rader, Ltd., either online or by calling us at (775) 823-9455.

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