5 Things You Need to Know About IRAs

By Markets Fool.com

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About three-fourths of Americans don't currently have an IRA, so it should come as no surprise that most people don't understand this type of retirement account all that well. Whether or not you already have an IRA, here are five things you should know about these accounts and what they can do for your retirement savings.

1. You might be able to use your money early

Generally, you need to wait until you're 59-1/2 years old to withdraw money from an IRA without paying a penalty. However, this rule isn't set in stone; there are several circumstances in which you might be able to use your savings early. Just to name a few:

  • You can use up to $10,000 toward a first-time home purchase.
  • You can use any amount to pay for college expenses.
  • Contributions to a Roth IRA (but not any investment gains) can be withdrawn at any time for any reason.

For a more in-depth look at when you might be able to use your IRA savings early, check out this article.

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2. Everyone can contribute to an IRA

Every American who has earned income can contribute to at least one form of IRA -- even if they're covered by a workplace retirement plan such as a 401(k). The maximum contribution for tax year 2016 is $5,500 (or $6,500 if you're aged 50 or older).

That said, the Roth IRA does exclude high earners. In order to make a full contribution to a Roth IRA, your modified adjusted gross income must be less than $117,000 if you're single or $184,000 if you're married and filing a joint tax return.If you're single with MAGI of $132,000 or more, or if you're married filing jointly with MAGI of $194,000 or more, then you can't contribute to a Roth IRA at all. These income limits apply whether or not you're covered by an employer's retirement plan. However, there is a back-door method of contributing to a Roth if you earn too much.

Meanwhile you can contribute to a traditional IRA no matter how much you make, but your ability to deduct those contributions depends on your income and other retirement accounts. If you're covered by a retirement plan at work, then your ability to take a traditional IRA deduction begins to phase out above MAGI of $61,000 and disappears completely above $71,000. If you're covered and are filing a joint return, then the limits are $98,000 and $118,000, respectively.

Finally, if you're not covered by a retirement plan, then your ability to deduct your traditional IRA contributions is limited only if your spouse is covered. In this case, the deduction phases out above a MAGI of $184,000 and disappears completely above $194,000.

3. You have until April 2017 to contribute for tax year 2016

You still have plenty of time to make a full contribution for the 2016 tax year if you're just getting started. The deadline is not the end of the calendar year.

Specifically, IRA contributions for a specific tax year can be made any time between Jan. 1 of that year and the tax deadline for that year's tax return, which usually falls on April 15 of the following year. For 2016, this means you'll have until April 15, 2017, to make your 2016 contribution.

4. There are more types of IRAs than traditional and Roth

For most Americans, traditional and Roth IRAs are the two available choices. If you have any self-employment income, though, there are a couple more options, both with significantly higher contribution limits.

  • SIMPLE IRA:There are two parts to SIMPLE IRA contributions -- employee and employer. If you're self-employed, then you count as both. As an employee, you can contribute up to $12,500 per year and an additional $3,000 if you're over 50. As the employer, you can match your own contributions, up to 3% of your total earnings.
  • SEP-IRA:A SEP-IRA allows annual contributions of up to $53,000, or 25% of your earnings, whichever is less. Be aware that calculating 25% of your earnings is more complicated than it sounds, so here's a more thorough description of how to do it.

Also keep in mind that you don't have to be completely self-employed to qualify. For example, if you work a full-time job for an employer and do some consulting work on the side, you can open one of these alternative IRA accounts for that income.

5. The awesome power of tax-deferred investing

The best thing about IRA investing is the power of tax-deferred growth. When you sell a stock in your IRA, you don't get a bill for capital gains taxes at the end of the year. Similarly, when you receive a dividend in your IRA, you won't have to pay dividend taxes on it. You simply pay taxes one time -- either when you withdraw the money (traditional) or when you initially contribute the money (Roth).

If you make a gain on a stock investment and sell your shares, then that entire profit is available to reinvest. And when you receive a dividend, you can use that entire payout to reinvest in additional shares or keep as cash.

Here's an example to illustrate the power of tax-deferred investing. Let's say you make two $5,000 investments in the same stock -- one in a taxable brokerage account and one in a Roth IRA. The stock pays a 4% dividend, and the share price increases by 5% per year, on average, for a 9% annualized total return.

The taxable investment would grow to $51,858 after 30 years, assuming the dividend qualifies for the preferential 15% tax rate. And when you sell, you'll have to pay long-term capital gains tax, which is currently 15% of your investment profit for most tax brackets. This makes the effective value of your investment $39,829 after 30 years of growth.

Meanwhile, your stock that was held in a Roth IRA would have grown to nearly $61,000, thanks to the compounding effect of not having to pay dividend tax. And, assuming you're over 59-1/2, you can withdraw the entire amount tax-free.

This is a simplified example, but it's a great illustration of the difference tax-deferred investing can make over long periods of time.

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