An individual retirement account, commonly referred to as an IRA, is a tax-advantaged investment account that provides tax-savings incentives. Contributions to these accounts may be tax-deductible or withdrawals may be tax-free.
Individual retirement accounts (IRAs) fall into the following categories:
Contributions to this type of retirement account reduce your taxable income by the contribution amount. When funds are withdrawn from the investment account, the funds are taxed at the individuals current ordinary income tax rate. There is an annual contribution limit imposed by the IRS, and the IRS usually allows for certain individuals to contribute more based on age – commonly referred to as a catch-up contribution. The IRS phases out the deduction for contributions based on household income. Starting at age 72, individuals must begin taking distributions from the retirement account, and the IRS requires a minimum annual distribution. Note that individuals cannot contribute to this type of IRA after the age of 70 1/2.
Contributions to this type of retirement account are made after taxes are withheld from income. However, distributions from this retirement account are tax-free, and the IRS does not require a minimum distribution from a Roth IRA account. However, there are income limitations for contributing to a Roth IRA based on total household income, so not all individuals are eligible to contribute to this type of IRA. Note that there is no age limit regarding contributions.
“SEP” stands for “simplified employee pension”. This type of retirement account is offered to self-employed individuals such as independent contractors, freelancers, and small-business owners. Distribution requirements for SEP IRAs are the same as those for traditional IRAs. Business owners who contribute to SEP IRAs on behalf of employees can deduct the contributions from their tax liability, however, employees are not allowed to make contributions to these accounts and taxes are paid on withdrawals.
This type of retirement account is offered to small businesses and self-employed individuals with 100 or fewer employees earning at least $5,000 each. Additionally, the employer may not offer any other type of retirement plan. The difference between an SEP IRA and Simple IRA is both the employer and employee can contribute to the account. Contributions are tax-deductible, and tax liability for this type of account is the same as that of a traditional IRA. There is an annual employee contribution limit set by the IRS, and a catch-up contribution is allowed.
Contributions can be made into multiple types of IRAs. Early withdrawals. from IRAs are allowed for specific expense types (first-time home purchase, education, medical expenses, or qualifying disability), however income tax will be due on the withdrawal and the IRS will assess a 10% tax penalty in addition to the income tax due.
IRAs have annual contribution limits. Generally, you (or your spouse) must have earned income to contribute to an IRA. There are withdrawal rules. You may face a 10% penalty and a tax bill if you withdraw money before age 59 1/2, unless you qualify for an exception. Rules regarding maximum contributions and income limits for IRAs change each year.
The tax benefits of an IRA allow savings to potentially grow faster than if funds were invested in a taxable account, and contributions reduce the individual or business’ income tax liability.