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Types of Individual Retirement Accounts (IRA)

MMI Copywriter

By Kim McGrigg, MMI Community Manager

One way to fund a retirement is through an Individual Retirement Account (IRA). An IRA is a tax-sheltered retirement account set up at a bank, investment firm, or insurance company. IRAs can be made up of mutual funds, stocks, bonds, bank deposit accounts, and most other types of investments.

All individuals who have earnings from salary or wage income are eligible to establish an IRA. In addition, unemployed spouses of wage earners are also eligible to open an IRA. The Internal Revenue Service establishes guidelines on a yearly basis regarding the amounts that can be contributed to an IRA. These guidelines take into account your income, income tax filing status, and age. For individuals 50 years old and over annual catch-up contributions are allowed to all IRAs. There are three types of IRAs.

Type 1: Traditional or deductible IRA
An advantage of the traditional IRA is that contributions can be taken as tax deductions in the tax year they are made. These deductions reduce your gross income, thus reducing your tax burden. Both contributions and earnings are tax-deferred until the funds are withdrawn. This type of account benefits individuals whose tax rate will decrease between the time of deposit and when the money is withdrawn. Workers who are not eligible to contribute to an employer-sponsored retirement plan can make contributions to a traditional IRA, regardless of income.

Type 2: Nondeductible IRA
The major difference between a traditional and nondeductible IRA is the ability to deduct yearly contributions on your income taxes. Contributions made to a nondeductible IRA are taxed as ordinary income in the year they are deposited and cannot be deducted from gross income. Thus, at the time you withdraw funds from a nondeductible IRA, you only pay income taxes on the earnings, as your yearly contributions have already been taxed. The major advantage of this type of IRA is the tax-deferred growth of contributions and earnings. Nondeductible IRAs provide an investment option for individuals who do not meet the eligibility criteria for a traditional IRA or for those whose adjusted gross income exceeds the limits for the Roth IRA. You may begin withdrawing money from traditional and nondeductible IRAs in the year in which you turn 59. Withdrawals before the age of 59 are permitted but are subject to a 10 percent penalty. In addition, early withdrawals are included in your gross income for tax purposes in the year the money is withdrawn. You must begin withdrawing from a traditional or nondeductible IRA during the year in which you turn 70 so that funds will be depleted based on life expectancy for your age.

Type 3: Roth IRA
This is the one you have probably heard the most about in recent years. The Roth IRA was established in 1998 and is very different from the traditional and nondeductible IRAs. Contributions to a Roth IRA are taxed as income in the year they are deposited, similar to the nondeductible IRA. Thus, contributions cannot be taken as tax deductions. However, at the time of withdrawal, the earnings on those contributions are not taxable. After age 59, all or part of a Roth IRA may be withdrawn free of income tax and without penalty. Under certain circumstances, the IRS allows penalty-free and tax-free early withdrawals on Roth IRAs. Two criteria must be met: the withdrawal must be used for a qualified purpose; and it cannot be made until five years after the account was opened. Examples of qualified purposes include the purchase of a first home, or the payment of higher education expenses. As with the other IRAs, nonqualified withdrawals are subject to a 10 percent penalty. Unlike the other two types of IRAs, there is no requirement that dictates when funds must be withdrawn from a Roth IRA. For example, the entire account may be left to your heirs without penalty.

For more information about preparing for your future, visit the section of our website dedicated to savings and investments.

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A budget strategy for back-to-school shopping

 

Summer is coming to an end, and that means the start of a new school year. Kids generally know what to expect – each new year presents new subjects to master, challenges to overcome, and opportunities for learning. Parents also face a challenge, particularly in the face of increasing unemployment numbers and the rising cost of just about everything: how to pay for all the school supplies children need for the year without overspending.

Retailers expect 2011’s back-to-school sales numbers to remain flat, according to survey details released recently by the National Retail Federation. The anxiety of back-to-shopping can be enormous for some parents as they worry about the hard hit on their wallets.

The best strategy for back-to-school shopping is to start with a plan. Begin by making a list. Many schools provide a list of the supplies students will need during the school year, so make sure you have it before you start. Sit down with your child and review the list. This allows you to determine exactly what you need and get organized before starting your shopping.

Here are a few frugal shopping tips to help you stretch your dollar this season without depriving your kids.

Look for special promotions. During this time of the year many stores offer amazing back-to-school sales. Watch out for special promotions such as free shipping and those “buy two for one” deals.

Reuse what you already have. Many school supplies such as backpacks, binders, and pens can have a second life. Take inventory of your leftover supplies from last year to see what can be reused. Also, school supplies from older siblings - that are still in good condition - can be passed down.

Do your shopping during “tax free days.” These days usually last for an entire weekend in either July or August. This is a great time to buy t-shirts, socks, and school uniforms.

Shop at local consignment stores. The end of summer is when many thrift stores are getting great, gently used clothing. These stores offer amazing pricing for quality merchandise. Thrift stores have strict policies for accepting items so you don’t have to worry about buying anything damaged.

Take advantage of Thursdays. Many department store sales begin on Thursday and run through Sunday. Many of us save our shopping for the weekend, but a trip to the mall on Thursday can produce great savings, and you’ll get first rights on merchandise.

Finally, to save on back-to-school shopping it’s important to set a budget and stick to it. With proper planning, you can prepare your children for another school year without breaking the bank. For more tips on raising a frugal family, check out MMI’s Youth and Money section.


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About Money Management International

Money Management International (MMI) is a nonprofit, full-service credit counseling agency, providing confidential financial guidance, financial education, counseling, and debt management assistance to consumers since 1958. MMI helps consumers trim their expenses, develop a spending plan, and repay debts. Counseling is available by appointment in branch offices and 24 hours a day, 7 days a week by telephone and Internet. Services are available in English or Spanish. To learn more, call
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