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Individual Retirement Account

An Individual Retirement Account (IRA) is a type of retirement savings plan in the United States that offers tax benefits. It is a trust that holds investments purchased with a taxpayer’s earned income for their benefit during retirement. IRAs are individual retirement arrangements as described in IRS Publication 590. Other similar arrangements include individual retirement annuities and employer-established benefit trusts.

Types

There are several types of IRAs:

  • Traditional IRA: Contributions are generally tax-deductible, meaning they reduce taxable income. Investments grow tax-deferred, and withdrawals during retirement are taxed as income. A traditional IRA may be either “deductible” or “non-deductible” depending on whether the contributions were tax-deductible. Introduced in 1974 with ERISA and popularized in 1981 with the Economic Recovery Tax Act.
  • Roth IRA: Contributions are made with after-tax dollars and are not deductible. Investments grow tax-free, and withdrawals of contributions are tax-free anytime. Withdrawals of earnings are tax-free if made after age 59½ and the account has been open for at least five years. Introduced in 1997 as part of the Taxpayer Relief Act.
  • myRA: A program introduced by the Obama administration in 2014, similar to a Roth IRA, but only allowed investments in government bonds. Phased out in 2017.
  • SEP IRA: Allows employers, typically small businesses or self-employed individuals, to make contributions to a Traditional IRA in an employee’s name, rather than to a pension fund.
  • SIMPLE IRA: A plan for small businesses that requires employer matching contributions. It has simpler administration compared to 401(k) plans.
  • Conduit IRA: A traditional IRA funded solely with transfers from qualified plans like 401(k)s. Usage has declined due to legislation allowing direct transfers between plans.
  • Self-Directed IRA: Allows broader investment choices, including real estate, private mortgages, and other alternative assets. Custodians may impose additional restrictions.
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Custodians

IRAs can be managed by various types of custodians, including:

  • Banks
  • Credit unions
  • Mutual fund companies
  • Brokerage firms
  • Life insurance companies

Funding

IRAs were introduced in 1974 with ERISA. Initially, contributions were limited to 15% of annual income or $1,500, whichever was less. The Economic Recovery Tax Act of 1981 increased the contribution limit and allowed contributions regardless of employment-based retirement plan coverage. Contribution limits have increased over time, with a 2024 limit of $7,000 for individuals under 50 and $7,500 for those 50 and older.

Restrictions

IRAs must be funded with cash or cash equivalents. Certain types of income, such as Social Security payments or child support, cannot be used for IRA contributions. Some investments, like collectibles and life insurance, are not allowed in IRAs. While the IRS outlines what is not allowed, custodians may impose additional restrictions.

Distribution of Funds

Funds in an IRA can be withdrawn at any time, but withdrawals before age 59½ may incur penalties unless certain exceptions apply. Required Minimum Distributions (RMDs) must begin by April 1 following the account owner’s 72nd birthday. Exceptions to early withdrawal penalties include medical expenses, disability, and educational expenses.

Bankruptcy Protection

In the case of bankruptcy, IRAs are generally protected from creditors up to a certain amount. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provides protection for IRAs up to $1,000,000 (adjusted for inflation). Inherited IRAs do not have this protection.

Borrowing and Loans

IRAs cannot be borrowed from, except for a 60-day period once per year through an indirect rollover. Loans must be non-recourse, meaning they cannot be personally guaranteed by the IRA owner.

Inheriting an IRA

If an IRA owner dies, different rules apply based on the type of beneficiary. Spouses can treat the IRA as their own, roll it over, or withdraw the assets. Non-spouse beneficiaries must withdraw assets within 10 years or based on their life expectancy if older than the deceased.

Statistics

Statistics from various sources show that IRAs are a common retirement savings tool. As of 2011, there were an estimated 43 million taxpayers with IRAs holding a total of $5.2 trillion. A small percentage of individuals have very high IRA balances, while many others have modest or no retirement savings.

Conclusion

IRAs are a key component of retirement planning in the U.S., offering various types to suit different needs and preferences. Despite their benefits, many Americans still face challenges in saving adequately for retirement. Understanding the different IRA options and rules can help individuals make informed decisions about their retirement savings.

 

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