An IRA is a financial instrument that allows your money to grow tax-free. You can invest in stocks, bonds, gold or any number of financial instruments and, using the power of compound interest and a long time horizon, hopefully end up with a substantial amount of money for your retirement needs.
There are tax consequences with an IRA. Even though your money grows tax free, you still must give Uncle Sam a cut. There are no free lunches, although an IRA is still a very good deal.
Making Contributions
Individual Retirement Accounts come in two basic forms. There is a regular IRA where you make regular contributions on a pre-tax basis and then pay taxes on the amount you withdraw and a Roth IRA where you pay taxes when you make a contribution and then have no tax liability when it comes time to withdraw from your account.
Currently, if you are 49 years of age or less and have earned income, you may put in up to $5,000 in either a traditional or Roth IRA for each tax year. For those age 50 or older, the IRS allows you to contribute up to $6,000 per year. Starting in 2012, those figures will be adjusted based on the rate of inflation.
You can make one lump sum payment or you can spread out your contributions in any way you want. For most people, it pays to make monthly or quarterly payments over the course of a year as the sooner you put money in an IRA, the sooner it can grow tax free. The only stipulation to contributions is that you must make them on or before April 15th to count for the previous tax year.
Withdrawing Money
IRA withdrawal rules must be observed. Generally speaking, you must wait until the age of 59 ½ before withdrawing funds from your IRA to avoid paying a 10% early withdrawal penalty. There are some exceptions to the IRA withdrawal rules that are outlined in IRS publication 590.
For example, if you have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income, use the distribution to buy a first home or you are disabled, you will not be subject to penalties, but still are responsible for any taxes that may be due.
Contrary to popular belief, IRA withdrawal rules do not prohibit you from removing money from your IRA any time you want, but you will probably pay a penalty and certainly be responsible for any tax liability. IRA withdrawal rules allow you to delay taking distributions up until the age of 70 ½. You do not have to take money out of your IRA when you hit the magical age of 59 ½. Instead, if you don’t need the income right then and there, you can allow it to continue to grow tax free up until age 70 ½ when you will be required to take minimum distributions each year.
Be sure to take out the minimum amount mandated by IRA withdrawal rules or you will be hit with a 50% penalty on the difference in the amount you were supposed to have withdrawn. You can find out the exact amount or percentage of your total IRA you must withdraw by talking to an IRS representative or going to the IRS website. Amounts required are based on actuarial tables that calculate the remaining years of your life.
In summary, as you approach the age of 59 ½, you can think about taking out some or all of your IRA holdings. With a Roth IRA, there are no tax consequences on either the money you originally deposited or the money you earned through growth. A traditional IRA will require you to pay taxes on the entire amount withdrawn, so be careful and only take out what you need. You will probably be in a lower tax bracket when you retire and consequently, the tax burden will not be so severe.
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