How it Works: Everything You Want to Know About IRA's
A Brief History
In 1974, due to mismanagement of corporate pension plans and rising concerns over Social Security, congress passed the Employee Retirement Income Security Act (ERISA). Which added regulations to company-sponsored retirement plans and also created The IRA or Individual Retirement Plan. Allowing you, for the first time, to have control over your retirement account and the investments within it.
How it works
To contribute to an IRA you must have earned income in at least the amount that you are contributing. The contribution limits for 2022 are $6,000 or $7,000 if you are over the of age 50. Your contribution can be invested in almost anything from cash, stock, and bonds, to mutual funds ETFs and even cryptocurrency. The money you contribute can be deducted from your earned income for that year. The growth of the investments is tax-deferred eliminating the need to worry about capital gains and generating taxable income from buying and selling investments. The benefit is that you have a lower taxable income and won't generate new taxes with the growth of your investments.
There are some Rules
To promote savings for retirement, the federal government put certain rules in place to try and discourage taking money out for other purposes. If you take the money before the year you reach the age (59 1/2) you will pay a 10% penalty and remember how I said you don't pay taxes now? That does not mean you don't pay taxes. Traditional IRAs are taxed when you withdraw the money. The amount is added to your earned income for the year. What if I don't need to use the money, then I will ever be taxed? The answer is yes! The government required that start taking money out of your IRAs starting at age 72 whether you need to or not. Why? So you can pay the taxes.
There are some Exceptions
Certain situations will allow you to take money out of your IRA before the age of 59 1/2 and avoid the 10% penalty though in all these situations the money will still be added to your earned income for the year.
First-time home buyer: You can take up to 10,000 from your IRA for the purchase of a house if you qualify as a first-time home buyer. To qualify as a first-time home buyer you must have not owned a home within the last 2 years.
Substantial and Equal Periodic Payments: Also known as rule 72T allows you to take money out of an IRA as long as you follow certain guidelines. The money must be withdrawn for a minimum of 5 years or until you reach the age of 59 1/2 whichever is greater. Meaning if you start taking withdrawals at age 40 you will have to stick with it for 20 years on the other hand if you take withdrawals at age 57 you will have to continue them until age 62. The government uses one of three methods to calculate the number of withdrawals amortization, annuitization, or required minimum distribution. You can pick the method that best fits your financial situation.
Unreimbursed Medical Expenses: If you have out-of-pocket medical expenses that are more the 7.5% of your adjusted gross income
Permanent Disability: If you qualify for the government's definition of permanent disability.
Education Expense: you can use your IRA to pay for qualified educational expenses for yourself or your immediate family. The withdrawal cannot exceed the amount of the qualified educational expenses.
For birth or adoption: you can take up to $5,000 from your IRA for expenses related to childbirth or adoption.
Reservist: a non-active reservist or National Guard member can make a withdrawal upon being called up for active duty.
Health Insurance Premiums: If you are unemployed for 12 weeks or more you can make a withdrawal to pay for your health insurance.
Is an IRA for me?
An IRA is a great tool for those who are currently maximizing their company retirement plan or don't have access to one. Getting a current tax deduction can be a bonus upfront but can also lead to more taxes later in retirement. Since the withdrawals from an IRA are added to your earned income for that year it will also count toward the income limits that make social security taxable. If that is the case then a ROTH IRA might be a better solution. I would urge you to consider all your options before deciding.