Individual Retirement Accounts, IRAs, have been an important retirement planning tool for the past 35 years. Originally intended for small business owners, self- employed workers and workers not covered by an employer’s pension plan, IRA’s can now be used regardless of the coverage under another plan.
The traditional IRA allows contributions that are initially tax deductible from your gross income. Both the contributions and their earnings grow tax-deferred, meaning taxes are not levied until the funds are accessed. Normally the funds aren’t accessed until after retirement, and the tax savings are recognized under the assumption that a worker’s retirement income will be lower than that of the ‘working’ years.
For example, if you contribute $2,000 to an IRA and you are in the 28% tax bracket, you will save $560 on taxes that year. When you begin taking distributions, if you are in the 15% tax bracket, you will be taxed $300 on that same $2,000 – meaning your tax savings are ultimately $260.
While anyone under the age of 70-1/2 may contribute to an IRA, you must have earned wages, self-employment income, social security income or tips to participate. Income from a partnership business, pension, rental income or interest income is not eligible for traditional IRA contributions. The limits for annual contributions are relatively low when compared to an employee sponsored plan such as a 401K, only $5,000 annually, with an additional $1,000 allowed for people who are 50 or older, known as a ‘catch up’ contribution.
The deductibility for a traditional IRA is also somewhat limited and depends on both annual income and whether you or your spouse participates in an employee sponsored plan. When you reach the age of 70 ½, you are required to begin drawing distributions from your IRA account, but there are methods to spread the distributions to your advantage.
An IRA, or any retirement plan for that matter, should be addressed within an estate plan. Discuss options with a knowledgeable estate planning professional to not only maximize the savings in your IRA account, but to minimize any potential tax liability.