Definition
An Individual Retirement Account (IRA) is a trust fund to which any individual employee can contribute for retirement savings. In 2010 and 2011, the contribution limit was up to $5,000 per year. For individuals aged 50 and above, the annual catch-up contribution is up to $1,000. The tax-deductibility of contributions depends on the employee’s income level and eligibility for an employer-sponsored pension plan. If an individual is an active participant in any qualified plan, and their Modified Adjusted Gross Income (MAGI) is $66,000 or more for single filers, or $109,000 or more for married couples filing jointly, they may not take a deduction for the IRA contribution.
Examples
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Traditional IRA: John, a single taxpayer, contributes $5,000 to a traditional IRA in 2011. His MAGI is below $66,000, so his contribution is fully deductible from his taxable income.
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Roth IRA: Sarah contributes $5,000 to a Roth IRA. Even though her MAGI is higher than the threshold for deduction on a Traditional IRA, she chooses a Roth IRA because qualified distributions will be tax-free.
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Catch-Up Contribution: Mark, aged 52, contributes $6,000 to his traditional IRA, which includes the $1,000 catch-up contribution since he is over 50 years old.
Frequently Asked Questions (FAQs)
1. What is an IRA?
An Individual Retirement Account (IRA) is a savings account with tax advantages that individuals can use to save and invest for retirement.
2. Are IRA contributions tax-deductible?
Whether IRA contributions are tax-deductible depends on the individual’s income level, tax filing status, and participation in any employer-sponsored retirement plans.
3. What are the contribution limits?
For 2010 and 2011, the contribution limit was $5,000 annually. Individuals aged 50 and older could contribute an additional $1,000 as a catch-up contribution.
4. What is Modified Adjusted Gross Income (MAGI)?
MAGI is an individual’s adjusted gross income (AGI) with certain deductions added back in. It determines eligibility for various tax benefits, including IRA deductions.
5. What happens if I contribute more than the allowed limit?
Contributions exceeding the limit are subject to a 6% excise tax for each year the excess amounts remain in the IRA.
Related Terms
SEP-IRA
A Simplified Employee Pension Individual Retirement Account (SEP-IRA) is a retirement plan that employers or self-employed individuals can establish. Contributions are made by the employer, and limits are higher compared to traditional IRAs.
Spousal IRA
A Spousal IRA allows a working spouse to contribute to an IRA on behalf of a non-working or low-earning spouse. This helps non-working spouses save for retirement.
Qualified Plan
A qualified plan is an employer-sponsored retirement plan that meets the requirements of the Internal Revenue Code and Employee Retirement Income Security Act (ERISA). Examples include 401(k) plans and profit-sharing plans.
Online References
- IRS: Types of Retirement Plans
- Investopedia: Individual Retirement Account (IRA)
- Fidelity: What is an IRA?
Suggested Books for Further Studies
- The Bogleheads’ Guide to Retirement Planning by Taylor Larimore, Mel Lindauer, Richard A. Ferri, and Laura F. Dogu
- IRAs, 401(k)s & Other Retirement Plans: Strategies for Taking Your Money Out by Twila Slesnick and John C. Suttle
- Retirement Plans: 401(k)s, IRAs and Other Deferred Compensation Approaches by S. Derrin Watson
Fundamentals of Individual Retirement Account (IRA): Retirement Planning Basics Quiz
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