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Polls indicate that most Americans haven't saved enough for retirement. While the reasons for this are varied, many people find themselves confused by the basics, wondering, "What is an IRA account, anyway?"
What is an IRA?
Individual retirement accounts, or IRAs, are a tax gift from Uncle Sam. Essentially, the IRA label on an account tells financial institutions and the IRS that the account is for retirement and gets special tax treatment.
There are 2 basic types of IRAs available to individuals:
Here's What Those Types of IRAs Have in Common:
- In 2016, you can put $5,500 into an IRA. The IRS re-evaluates contribution limits yearly.
- Savers over age 50 get to put away an extra $1,000 in catch-up contributions.
- Full retirement age is 59 1/2, at which time penalty-free withdrawals can be taken.
- Cash and certificates of deposit, stocks, bonds, mutual funds and exchange-traded funds can all be held in IRAs. But that's not all: There are a few surprising investment options for IRAs, as well.
The main requirement for contributing to an IRA, either Roth or traditional, is that you must have earned income, says Denise Halford Holder, CFP professional, first vice president of wealth management at Noyes Group in Indianapolis.
A non-working spouse is an exception, however. If one person in a married couple has earned income, the spouse can still put money away, she says.
Here's The Deal With Penalties
Don't let potential early withdrawal penalties scare you.
The Roth IRA allows a little more flexibility for savers who might need to access their funds.
That's because your contributions to a Roth IRA can be taken out at any time. The earnings, however, must stay in the account until it has been open for 5 years and the owner is at least age 59 1/2 or the distribution is subject to income taxes and the 10% penalty.
The penalty for early withdrawals from a traditional IRA is much easier to remember. Anything taken out before age 59 1/2 is going to be taxed and penalized.
There are a few circumstances where the IRS has deemed it OK to tap your IRA early.
What is a Roth IRA?
- Contributions to the account are made after-tax.
- Withdrawals in retirement are tax-free.
- Eligibility to contribute to a Roth IRA is phased out as income rises.
- Contributions and earnings can be withdrawn after age 59 1/2 if the account has been open for 5 years.
- Savers can access contributions anytime and pull them out of the account.
- Savers can contribute at any age as long as they are earning money. The break for non-working spouses applies again here.
- No withdrawals are required during the account owner's lifetime.
What is a Traditional IRA?
- Savers get a tax deduction for the year the contribution is made.
- Tax deductions are phased out as income rises. If you or your spouse is covered by a retirement plan at work, you may not be eligible for a full deduction, depending on your income.
- Withdrawals are mandatory beginning at age 70 1/2.
- Contributions and earnings can be taken out after age 59 1/2 and are subject to income tax.
- Only individuals under age 70 1/2 can open a traditional IRA.
"Traditional IRAs are nothing more than a tax-deferred retirement account," says Burt Drobnis, senior vice president at Lantern Investments in San Francisco.
"Unfortunately, more people don't take advantage of it," he says.
About half of Americans over age 55 have no retirement savings, according to a study released by the Government Accountability Office in May 2015.
You don't have to save the maximum every year. Just start saving a little in an IRA and Uncle Sam will give you a little tax boost to turbocharge those savings.
Copyright 2016, Bankrate Inc.