Have you started planning for retirement yet? It is never too early to start thinking about it. Most of us would like to look forward to a more comfortable retirement than Social Security can provide. The purpose of an IRA is to do just that, allow you to plan, save, and invest in your future. An IRA can also be used to help pay for other important purchases, while providing wonderful tax breaks. So, what is an IRA and how does it work?
Definition of an IRA
An IRA, or Individual Retirement Account, is essentially a tax-deferred savings plan, established under the applicable IRS guidelines. There are four basic types of IRAS, all with their own specific benefits. Traditional IRAs and Roth IRAs can be created by individuals. A Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are both provided through an employer. All IRAs are “fully vested” which means that all contributions and earnings belong to the individual, including those contributions made by employers.
How are they different?
The differences are based on when the funds are taxed and when they can be withdrawn. With a Traditional IRA, the funds are placed into the account “pre-tax.” Contributions made to a Traditional IRA are tax-deductible. Investment earnings are not taxed while they remain in the IRA. When you withdraw funds from a traditional IRA after you retire, all of the money you take out is taxed as ordinary income. When you reach age 59½, you can withdraw from the account. Taxes are then paid on the amount you withdraw. A SEP IRA and the SIMPLE IRA, which both involve employer contributions, provides the same tax advantages as a Traditional IRA.
When cash is placed in a Roth IRA, it is done “after-tax.” This means you are not allowed to deduct your contributions. However, when you reach age 59½, the funds can be distributed tax-free.
Limitations on Contributions
There are limitations on the total amount of contributions that can be made to an IRA account. In 2014, the total contributions of your Traditional and Roth IRAs can be no more than $5,500. If you are age 50 or older, the limit is $6,500. However, if your taxable compensation for the year is less than that amount, then your limit is the amount of your taxable compensation.
The contribution limits for an SEP and SIMPLE IRA are higher. The total amount an employee can contribute to a SIMPLE IRA cannot exceed $12,000 in 2014 and $12,500 in 2015. The maximum contributions for an SEP in 2014 is $52,000 and $53,000 in 2015.
Are there penalties for early withdrawal?
Yes. If you make a withdrawal from a Traditional IRA before you are age 59½, you will be assessed an additional 10% tax on the taxable amount. There are a few limited exceptions for qualified educational expenses, the purchase of your first home, or for certain medical expenses. Early withdrawals from Roth IRAs are subject to similar rules. You are limited to a total of $10,000 for home purchases. Though there is no penalty, you will have to pay income taxes on early withdrawals, unless it is used to purchase a first home or for educational costs.
If you have questions regarding IRAs, or any other retirement planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.