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IRA Basics

There are two common ways to save money for retirement; one is by using a 401(k) and a second is by using IRA.

An IRA is an Individual Retirement Account that provides savings for retirement either A) tax free or B) tax-deferred.  There are several types of IRAs and many rules and regulations to observe.  One word of caution is that if you do not follow the rules, you can be forced to forfeit your IRA. 

A traditional IRA allows a tax-deductable contribution of up to $4,000 a year up until the age of fifty and then the amount increases.  When you contribute to your IRA, the amount is deducted from your year’s end gross income reducing your income tax liability.  When the money is withdrawn, it is subject to income tax.  If you withdraw the money before you are fifty-nine and one half, it is subject to a ten percent penalty with exceptions for higher education or the purchase of a home.  Standard income tax is applied, but the penalty of ten percent is waived.  You must begin distributions by the age seventy and one half.  There is no mandatory age for withdrawal.

A Roth IRA is an IRA with contributions after the contributor’s wages are taxed.  A distribution from an IRA must be qualified to be tax-free.  Any interest earned on a Roth IRA will be taxed if withdrawn early.  You can have more then one Roth IRA, but the IRS looks at them all as one IRA.

If you have more then one IRA, you must make your distributions in a certain order.  Here's the order for your distributions:

            a. from non-taxable contributions made to a Roth IRA annually
            b. from conversion contributions made on the first-in, first-out rule
            c. from earnings

Be aware that different companies may have their own stipulations and rules for withdrawing funds.

To be qualified, the distribution must be one of the following if withdrawing before the age of fifty-nine and one half.. 

1) Distributed after the date you become age 59 ½.

2) Distributed to your beneficiary, or to your estate, after you die.

3) Distributed to you after you become disabled within the definition of the IRS Code Publication 590.

4) A distribution used to pay for qualified first-time homebuyer expenses  up to $10,000.  

5) A distribution is used to pay for any medical expenses that are more than 7.5% of your adjusted gross income.

6) A distribution for your medical insurance premium if you have been on unemployment for more than 12 weeks.

7) A distribution to pay back taxes due to the IRS.

8) A distribution to pay for higher education for the owner or for a family member.

These are the first set of rules for “qualification.” This means that the distribution is qualified to be tax-free.

There are another set of rules. The second rule that must be conquered is the five-year tax rule (which is not the same as a five-year calendar year).

Essentially, the five-tax-year requirement states that it has been five tax years (not five calendar years-the tax year ends on April 15) since you made your first contribution to your Roth IRA. If you make your first withdrawal before this period, you will be subject to early withdrawal fees and you will have to pay taxes on your withdrawal amount.

In short, you can make withdrawals without fear after the age of 59 ½, if it has been five tax years since your first contribution. If you have met the five tax year requirement, but are younger than 59 ½, then you have to meet one of the exceptions listed above to avoid having to pay considerable taxes and fees for early withdrawal.

Individuals who file taxes using single status are eligible for full contribution as long as they don't exceed $95,000 per year in earnings, and $110,000 for partial contributions. Joint filers face an earnings cap at $150,000 and $160,000 for full and partial contributions respectively.

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