IRA for the Independent

From the response we got to yesterday’s post on contributing to a Roth IRA if your employer does not offer matching contributions to your 401K, we realized it’s time for a back-to-basics crash course on IRAs.  This is also a timely issue, as the increase in the number of self-employed, unemployed, and underemployed people due to the economic downturn means that many more people who used to rely on automatic transfers into their 401Ks will have to set up and learn to manage IRAs instead.

So here are the basics:

“IRA” stands for “individual retirement account,” and there are at least four types of them.  The less common SEP IRA and SIMPLE IRA may be available through your employer and involve making contributions straight from your paycheck.  The two more popular ones, and most relevant for the self-employed, however, are the traditional IRA and Roth IRA.  The main difference between them is when they are taxed: contributions to a traditional IRA can be deducted from your income tax (i.e., the contributions are tax-free) but you pay income tax on them when you withdraw them later in life; in contrast, contributions to a Roth IRA are not deductible, but are then allowed to grow tax-free.

Traditional IRA

Eligibility: You can set up and contribute to a traditional IRA if you have taxable compensation (i.e., income from work, such as wages, salaries, self-employment income, commissions, etc.) and are less than 70-and-a-half years old.

Contributions limits: In general, your contribution limit is the smaller of $5,000 or your taxable compensation for year.  This limit is a combined limit for all of your traditional and Roth IRAs.

Deduction: Not everyone who is eligible to contribute to a traditional IRA can take a full deduction on their contribution.  If you are not covered by a retirement plan at work (e.g., self-employed) and are single, head of household or a qualifying widow(er) or are married and your spouse is also not covered by a retirement plan, you can take a full deduction.  But if you or your spouse is covered by a work retirement plan, the amount of the deduction you can take will depend on your AGI.  For more information, see tables 1-2 and 1-3 in the IRS’s Publication 590.

Withdrawals: Withdrawals from traditional Roth IRAs count as income and will be taxed when you file your income tax for the year you make a withdrawal.  Any withdrawal made before you are 59-and-a-half will incur an additional 10% tax.  If you are over 59-and-a-half years old, you can make withdrawals from the account without incurring the additional tax, and once you are 70-and-a-half, you are actually required to make withdrawals.

Roth IRA

Eligibility: Anyone can set up a Roth IRA, but to make a contribution your modified AGI must be less than $120,000 if you are single and $176,000 if you are married and filing jointly or a qualifying widow(er).  An interesting article on the WSJ shows how to get around that limitation, however.

Contribution limits: As with the traditional IRA, your contribution limit to a Roth IRA is generally the smaller of $5,000 or your taxable compensation for year, and this is actually a combined limit for all of your traditional and Roth IRAs.  However, your contribution limit to a Roth IRA is also reduced if your AGI is at least $105,000 if you are single and $166,000 if you are married or a qualifying widow(er).

Withdrawals: Withdrawals from Roth IRAs are not included in your gross income when filing your income tax, and are thus income-tax-free.  But any withdrawal from your Roth IRA made before you reach the age of 59-and-a-half will incur the additional 10% tax.  Once you reach 59-and-a-half years of age, there are no taxes for withdrawing from your Roth IRA and you are never required to withdraw from it either.

Now that you know the basics on IRAs, here are two other important facts.  First, the deadline for making contributions to traditional and Roth IRAs is actually the day you file your taxes.  That is, before you start panicking that you do not have enough time to save for your maximum contribution, note that you have until April 2010 to make your 2009 IRA contribution.  And second, if you make a contribution and then change your mind within the same year you made it, you can withdraw the contribution (plus the interest or income earned on it) and it will be as if it never happened.  Of course, you cannot take a deduction on your contribution if you do that.  However, you also will not have to pay any penalties or fees, though you will have to report the interest or earnings from it as income when filing your income tax.

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One Response

  1. Of course, what a great site and informative posts, I will add backlink – bookmark this site? Regards, Reader.

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