IRAs - A Basic Overview

With the tax and IRA (individual retirement arrangement) deadline approaching on April 15, I thought it might be a good idea to review the basics of IRAs. In general terms, an IRA is an investment account in which a person can set aside income up to a specified amount each year and usually deduct the contributions from taxable income, with the contributions and interest being tax-deferred until retirement. One of the benefits of a traditional IRA is that a taxpayer can contribute to the IRA after the tax year has ended (but before April 15), and then receive a tax deduction for such contribution for the prior tax year. Thus, a contribution made in March 2003 may be deductible on the taxpayer’s 2002 tax return. This allows the taxpayer to do some “afterthought” tax planning.

There are generally two types of IRAs: (I) a Traditional IRA, and (II) a Roth IRA. Contributions to a Traditional IRA are generally limited to $3,000 per year (or $3,500 if the taxpayer is 50 years of age or older). The amount of the deduction for the contribution depends on whether or not the taxpayer is covered by an employer maintained retirement plan. If the taxpayer is not covered by such a plan, then there is no limitation to the amount of the deduction the taxpayer can take (i.e. the taxpayer can deduct the full amount of the contribution). If, on the other hand, the taxpayer is covered by an employer maintained retirement plan, then there are certain phase-out rules that apply starting at $54,000 for married couples filing jointly and $34,000 for taxpayers filing single or as head of household. Finally, under the Traditional IRA, all of the taxpayer’s money grows tax-free, and the taxpayer does not have to pay taxes on the interest/capital gains/dividends earned in the IRA until such is withdrawn by the taxpayer.

The Roth IRA has similar contribution limits as the Traditional IRA. The main difference, however, between a Traditional IRA and a Roth IRA is that contributions to a Roth IRA are not tax deductible. But, contributions to a Roth IRA may be withdrawn at retirement tax-free. Thus, the taxpayer gives up a current year tax deduction for the right to have his or her contributed money grow and be withdrawn at retirement age tax-free.

Finally, the taxpayer must remember that in most cases, there is a 10% penalty for early withdrawals (i.e. withdrawals before retirement age). There are, however, some exceptions. For example, the IRS allows first-time homebuyers to withdraw certain amounts to buy, build or rebuild a home without having to pay the 10% penalty. The penalty is also waived for taxpayers to take money from their IRAs for qualified higher education expenses. In any case, you should always speak to your tax professional before making any withdrawals from your IRA.

This article was contributed by Craig Habicht, President of Liberty Tax Service in Hagerstown, 301-733-6990.