What is an IRA?
An IRA or Individual Retirement Account is a tax-deductible retirement savings tool primarily used by investors who do not have access to a 401(k). When President Gerald Ford signed the Employee Retirement Income Security Act or ERISA over thirty years ago, IRAs became the single most important way to enhance the retirement security of all Americans.
It gave people who were not covered by retirement plans in the workplace the opportunity to save money and for those that were retired, the ability to protect it.
Workers without pension plans or 401(k)s were now able to deduct a portion of the taxes they had paid by investing for their future. They would be able to employ private financial institutions to achieve the goal of a better-funded retirement. This new piece of legislation created the Individual Retirement Accounts or IRAs.
This retirement tool was so successful, one out of every four Americans who invest have money in this type of account.
An IRA for Every Need
One of the key elements of an IRA is flexibility. Investors could invest their money where they thought it would do the best. In the early days after the creation of the IRA, those investments were primarily in funds at banks and thrifts. Eventually, the returns offered by the stock market coupled with the growth of the mutual fund industry swayed these investors to invest in equities.
Once investors began using mutual funds, these new IRA investors were faced with some individual challenges. These investors, many of whom had never invested in the stock market needed to determine what kind of investor they were, how much risk they could tolerate and how much they could afford to contribute.
Mutual funds redesigned their accessibility to this group of investors. It made the sign-up process easy. It made contributions automatic, often taking them from bank accounts directly for deposit into the fund. And they gave these new individual investors thousands of choices.
So many choices in fact, many were prone to make the wrong ones.
Congress didn't stop with the creation of the IRA, now commonly called the traditional IRA. They continued to add offerings to more types of investors interested in saving for their retirement.
They legislated changes in eligibility and continued to increase contribution limits. By 1978, new access was given to small companies with the Simplified Employee Pension or SEP-IRA‹an employer-based IRA. Less than ten years later, all workers under the age of 70 1/2 were given access to tax-deductible contributions.
That kind of "universality" was later changed by enacting certain income limits. What was permitted was tax-deductible contributions by workers who did have employer-sponsored retirement plans.
By 1996, the Savings Incentive Match Plan for Employees, or SIMPLE IRA, an account targeted to small businesses was introduced. This was different from the SEP-IRA, which could be used by businesses of any size although it was designed for smaller ones. The SIMPLE IRA focused on enterprises of less than 100 employees.
The Taxpayer Relief Act of 1997 gave birth to the Roth IRA , a sort of hybrid IRA that allowed the investor to make after tax contributions but defer the tax bill on the earnings.
Defer or Deduct
IRAs are different from company sponsored retirement plans.401(k) plans defer taxes by investing the money before the taxes are taken out of your paycheck. IRAs allow you to deduct the contributions you make from your taxes at the end of the year.
The earnings are taxable once you begin to withdraw the money. Distributions cannot be taken before 59 1/2 and must begin once you reach 70 1/2. Stiff penalties are assessed against those who withdraw money from these accounts prior to 59 1/2.
Roth IRAs on the other hand defer the taxes on the accumulated growth of the deposits. The money that is put in a Roth has already been taxed. You cannot be penalized for withdrawing that money, although the same types of penalties are paid if the tax-deferred income is withdrawn.
How much Can You Contribute?
As it became more obvious that the income needs in retirement would be rising, Congress increased the amount of money the individual could contribute to the plan and deduct from their income each year. Here are the latest numbers for 2012 according to the IRS:
2012 IRA contribution limits that are eligible for a tax deduction are the lesser of $5,000 and your taxable compensation for 2012. This limit can be invested solely in a traditional IRA or a Roth IRA or split between the two retirement accounts. You're also eligible to add an additional $1,000 in catch-up contributions if you’re 50 years old or older before December 31, 2012.