Since April 15th is just around the corner and you have until then to make your last minute 2008 contributions, I thought I’d go over the basics of IRAs. I’m not a tax advisor, so I won’t be telling you which one is best for your specific situation; however, I can give you the basics on the different types so you have an idea of how they work.

If you’ve already got one and understand it, great. If not, hopefully this will give you the information you need.

Definition of an IRA

An Individual Retirement Account (IRA) is a savings account that allows individuals to save towards retirement in a tax-advantaged manner. There are two types of IRAs, the traditional IRA and the Roth IRA.

Now, don’t let that definition confuse you. An IRA is an umbrella account that can have different vehicles within it. For example, an IRA can house a savings account, CD, annuity, or mutual fund. The term “savings account” in the definition above is used loosely.

Individual

- The individual part means there can only be one human owner per IRA account.

• There cannot be multiple owners, IRAs cannot be put into your beloved
  pet’s name, nor can it be in a trust’s name. You can have a trust named
  as beneficiary for your IRA, although I’m afraid your out of luck with the
  beloved pet. Sorry.

Retirement

- This should be pretty self-explanatory, but the purpose of these accounts is to help the owner save for retirement. With pension plans disappearing and the lack of social security for future generations, it’s important that we start taking care of our retirement needs as soon as possible.

• According to the Social Security Administration, most
  people will need to rely on personal savings for up to 60% of their
  retirement income. That study was released in 2005. I’m willing to bet
  the number has increased since then.

Account

- An IRA is an account, not an investment, though as I mentioned, it can contain investments within it’s umbrella.

IRA Benefits to You

So, what’s the benefit of owning an IRA? Well, it largely depends on which one you go with and you personal situation. However, in general, you can expect the following benefits.

Traditional IRA tax advantages:

- Earnings are always tax-deferred until withdrawn. This means you won’t receive a 1099-INT at the end of the year. The only time you receive a tax document for your traditional IRA is if you take a distribution, in which case, you’ll receive a 1099-R.

- Contributions are often tax deductible, which means you’ll pay less in income taxes for the year the contribution is made.

- As always, please consult your tax advisor with specific questions about
this as there are three factors that determine deductibility:

1. Active participation in a qualified retirement plan
2. Filing Status
3. Modified Adjusted Gross Income

Roth IRA tax advantages:

- As with the traditional, earnings are always tax-deferred until withdrawn.

- What’s different about a Roth is that some earnings may be withdrawn tax-free under certain circumstances.

- In order to withdraw earnings tax-free, the owner must have a qualified
distribution. In order to be a qualified distribution, the withdrawal must
meet the following criteria:

1. Owner is age 59 1/2 or older, is disabled, is deceased, OR the distribution qualifies for a first-time home purchase; AND
2. The owner has had the Roth IRA for 5 years.

So, to sum it up, a traditional IRA has tax deferred earnings and possible tax deductions at the end of the year. A Roth IRA has tax deferred earnings and the possibility to with earnings tax-free.

Contribution Eligibility

There are some eligibility requirements to contribute to an IRA, whether it be traditional or Roth. Make sure that you understand it is your responsibility to know whether or not your eligible to make contributions. Your financial institution or brokerage firm may make suggestions, but ultimately, the responsibility lies with you.

Both the traditional and the Roth have two eligibility requirements which have to be met in order to make a contribution.

Traditional IRA Eligibility:

- Earned Compensation

- Age: the owner must not reach age 70 1/2 at any time during the year for which the contribution is made

Roth IRA Eligibility:

- Earned Compensation

- Income Limit: The owner’s modified adjusted gross income (MAGI) must not exceed IRS limits.

Now, let me back up for just a second. As you can see, earned compensation is listed as a requirement for both IRAs, but what is considered earned compensation? Well, as you can imagine, the IRS is pretty strict with what is and isn’t considered compensation.

Compensation

• Wages
• Salaries
• Tips
• Bonuses
• Taxable Alimony
• Commissions
• Professional Fees
• Jury Pay
• Directors Fees
• Combat Pay

Not Compensation

• Interest
• Royalties
• Dividends
• Rental Income
• Unemployment Compensation
• Retirement Income
• Disability Pay
• Child Support
• Separation and Early Retirement
• Aid to Families with Dependent Children
• Temporary Aid for Needy Families
• Social Security

Compensation is defined as amounts derived from or received for personal services actually rendered, though to be honest, I wonder what services were rendered for alimony, but we won’t go there. Ahem.

For the age restriction, the IRS even has some helpful hints on how to tell when you’re 70 1/2. For people born from January 1 to June 30, that will be the year of their 70th birthday. For those born from July 1 to December 31, the 70 1/2 year will fall in the year of their 71st birthday.

Confused? Think of it this way, let’s say you were born March 23, 1939. That means this year you turned 70. It also means you are ineligible to contribute because you will reach 70 1/2 on September 23, 2009. But, if you were born November 19, 1939 you could still contribute for 2009 because you won’t actually be 70 1/2 until May 19, 2010.

Contribution Limits

Contribution limits can adjust annually, though for 2009 they remained the same, $5000 with $1000 catch-up for anyone 50 and older.

This means that you are only allowed to contribute up to $5000 if you’re under 50 and up to $6000 if you are 50 and over. This is also an aggregate total for all of your IRAs, traditional and Roth. If you exceed your annual contribution limit, you face some penalties from the IRS, so make sure you keep track of what you’re contributing.

Spousal Contributions

If a person doesn’t have individual earned compensation, they must file a joint federal income tax return with a spouse who earns compensation during the year for which the contribution was made.

That means that a married person filing joint with their spouse can treat the couple’s joint compensation as their own. However, there are some requirements that must be met:

- Each spouse who wants to make a contribution must have their own IRA.

- The couple must file a joint tax return.

- If the contribution is for a traditional IRA, the owner must meet the age requirement.

- If the contribution is for a Roth IRA, the joint MAGI must be less than the income limit.

Contribution Deadline

The contribution deadline for a year is tax day. This usually falls on April 15th, but if the 15th falls on a weekend or holiday, then the contribution deadline is the next business day. Please note, the contribution deadline is NOT extended if you receive an extension for filing your tax return. But, a mailed contribution counts as ‘on-time’ as long as it is postmarked by the tax return deadline.

So, for those of you who haven’t made your 2008 contributions, you still have until April 15th to do so. You can make your 2009 contributions anytime from January 1, 2009 until April 15th, 2010.

And there are the basics of IRAs, at least when it comes to defining them and discussing contributions. I’ll write a separate post on distributions and tax reporting since this was kind of long.

What questions about IRAs do you have? Did you find this information helpful? What has your IRA experience been like this year?

Related posts:

1. IRA Basics: Part 2
2. Basics of budgeting money
3. What I Think of Dave Ramsey
4. Bankruptcy: The Basics
5. Deposit Insurance: Recession-proof your savings