INDIVIDUAL RETIREMENT ACCOUNTS (IRAS)

An individual retirement account (IRA) is a tax-deferred retirement program in which any employed person can participate, including self-employed persons and small business owners. In most cases, the money placed in an IRA is deducted from the worker's income before taxes and is allowed to grow tax-deferred until the worker retires. IRA funds can be invested in a variety of ways, including stocks and bonds, money market accounts, treasury bills, mutual funds, and certificates of deposit. Intended to make it easier for individuals to save money for their own retirement, IRAs are nonetheless subject to a number of complex government regulations and restrictions. The extent of annual contributions, and the tax deductibility thereof, are dependent on the individual worker's situation.

The main difference between IRAs and employer-sponsored retirement plans is that IRA funds—although held by a trust or annuity—are under the complete discretion of the account holder as far as withdrawals and choice of investments. For this reason, IRAs are known as self-sponsored and self-directed retirement accounts. Even combination plans that allow employers to make contributions, like Simplified Employee Pension (SEP) IRAs, are considered self-sponsored since they require the employee to set up his or her own IRA account. A special provision of IRAs allows individuals to roll over funds from an employer-sponsored retirement plan to an IRA without penalty.

IRAs were authorized by Congress in 1974 as part of a broader effort to reform laws governing pensions. Recognizing that employers facing intense competition might decide to cut costs by reducing the retirement benefits provided to employees—and that government programs such as Social Security would not be enough to fill in the gaps—Congress sought to encourage individual taxpayers to undertake long-term savings programs for their own retirement. The Internal Revenue Service responded by making provisions for individual retirement accounts in section 408 of the tax code. IRAs quickly became recognized as one of the most opportunistic and flexible retirement options available, enabling workers to control their own preparations for the conclusion of their working lives.

IRA PROVISIONS

In the original provisions, elective pre-tax contributions to IRAs were limited to $1,500 per year. The maximum annual contribution increased to $2,000 in 1982, but new restrictions were imposed upon workers who were covered under an employer's retirement plan. For example, such workers were not eligible to deduct their total IRA contributions unless their adjusted gross income was less than $25,000 if unmarried, or less than $40,000 if married. A partial deduction was available for single workers who earned up to $35,000 and married workers who earned up to $50,000, but no deductions were allowed for people with higher income levels. These restrictions did not apply to self-employed individuals and others who did not participate in an employer's plan. In 1998, the income limits for people covered under an employer's retirement plan were increased to $30,000 for unmarried workers and $50,000 for couples.

The way the tax code was written, individuals were intended to begin making regular withdrawals from their IRAs upon retirement. These withdrawals would be considered income and subjected to income tax, but the individual was presumed to be in a lower tax bracket by this time than they had been during their working years. "Ordinary" distributions from an IRA are those taken when a worker is between the ages of 59½ and 70½. Though workers are not required to begin receiving distributions until they reach age 70½, most establish a regular schedule of distributions to supplement their income during this time. The total annual distributions cannot exceed $150,000 per year, or they are subject to a 15 percent penalty in addition to the regular income tax. "Early" withdrawals, or those taken before a worker reaches age 59½, are subject to a 10 percent penalty on top of the regular income tax, except in cases of death or disability of the account holder. This penalty is intended to discourage younger people from viewing an IRA as a tax-deferred savings account. "Late" withdrawals, or those beginning after a worker reaches age 70½, are subject to a whopping 50 percent penalty. Since IRAs are supposed to provide income for the worker during retirement rather than inheritance for others after the worker's death, the government imposed an especially stiff penalty to ensure timely distributions.

Subsequent legislation—in particular, the Tax Reform Act of 1986—has refined the scope, provisions, and requirements of IRAs so that other forms are available besides the basic, individual "contributory" IRA. As outlined by W. Kent Moore in The Guide to Tax-Saving Investing, the different IRA variations include: 1) spousal IRAs, which enable a working spouse to contribute to an IRA opened for a nonworking partner; 2) third-party-sponsored IRAs, which are used by employee organizations, labor unions, and others wishing to contribute on workers' behalf; 3) Simplified Employee Pensions (SEPs), which enable employers to provide retirement benefits by contributing to workers' IRAs; 4) Savings Incentive Match Plan for Employees (SIMPLE) IRAs, which require employers to match up to 3 percent of an employee's salary, or $6,000 annually, plus allow employees to contribute another $6,000 per year to their own accounts; 5) rollover contribution accounts, which allow distributions from an IRA or an employer's qualified retirement plan to be reinvested in another IRA without penalty; and 6) Roth IRAs, which enable single people with an annual income of less than $95,000 and married couples with an annual income of less than $150,000 to make a nondeductible contribution of $2,000 per year, whether they are covered by an employer's plan or not. It is also possible for those earning less than $100,000 per year to convert a regular IRA to a Roth IRA by paying any deferred income tax. Though money placed in Roth IRAs is subject to taxes when invested, the earnings grow tax-deferred and the withdrawals are tax-free after five years.

FACTORS TO CONSIDER

Those interested in opening an IRA should familiarize themselves with the current regulations governing the amounts that may be contributed, the timing of contributions, the criteria for tax deductibility, and the penalties for making early withdrawals. They should also shop around when investigating financial institutions that offer IRAs—such as banks, credit unions, mutual funds, brokerage firms, and insurance companies—inasmuch as fees vary from institution to institution, ranging from no charge to a one-time fee for opening the account to an annual fee for maintaining the IRA. Financial institutions also differ in the amount of minimum investment, how often interest is compounded, and the type and frequency of account statement provided. There is no limit to the number of IRAs an individual can open, as long as he or she does not exceed the maximum allowable annual contribution.

Another important factor to consider, in addition to the trustee of the account, is where the IRA funds should be invested. Individuals have a wide range of investment options available to choose from—including bank accounts, certificates of deposit, stocks, bonds, annuities, mutual funds, or a combination thereof—each offering different levels of risk and rates of growth. According to the Entrepreneur Magazine Small Business Advisor, the ideal IRA investment is one that is reasonably stable, can be held for the long term, and provides a level of comfort for the individual investor. Most financial advisors advise against playing the stock market or investing in a single security with funds that have been earmarked for retirement, due to the risk involved. Instead, they recommend that individuals take a more diversified approach with their IRAs, such as investing in a growth-income mutual fund, in order to protect themselves against inflation and the inevitable swings of the stock market.

The decision about where IRA funds should be invested can be changed at any time, as often as the individual deems necessary. Switching to a different type of investment or to a mutual fund with a different objective usually only requires filling out a transfer form from the sponsoring financial institution. Since the IRA simply changes custodians in this type of transaction, and never passes through the hands of the individual investor, it is not subject to any sort of penalty or tax, and it is not considered a rollover.

Despite the number of decisions involved, IRAs nonetheless provide an important means for people to save for their retirement. "The advantages of IRAs far outweigh the disadvantages," as Moore noted. "Earnings for either deductible or nondeductible IRAs grow faster than ordinary savings accounts, because IRA earnings are tax deferred, allowing all earnings to be reinvested. Even when withdrawals are made, the remaining funds continue to grow as tax-deferred assets."

INDIVIDUAL RETIREMENT ACCOUNTS (IRAS)

IRA PROVISIONS

FACTORS TO CONSIDER

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