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Summary

Individual Retirement Arrangements, generally known as IRAs (and referred to by financial institutions as Individual Retirement Accounts), are a great way to save money for retirement or in case you become disabled. However, there are very specific rules about the amount of money you can put into an IRA, (contributions), what you can do with the money in the IRA, and when you can take the money out (distributions).

There are several different types of IRAs, each of which have their own features. The two most common are Traditional IRAs and Roth IRAs.  Consider the differences when deciding which is best for you.

Since IRAs are meant to help people save money for retirement, there is generally a penalty for taking money from the account before you reach age 59 1/2. However, you can withdraw money without penalty before age 59 1/2 if you become "disabled" as defined by the Internal Revenue Service and under certain other circumstances. Depending on the type of IRA you own, withdrawals might also be free of any income taxes.

If you are considering or have a Traditional IRA, keep in mind that certain withdrawals are required or there is a penalty for not making the withdrawal..

The earlier in the year you make an IRA contribution, the longer you receive tax-favored investment returns. (If your circumstances change and you become ineligible during the year to make a contribution, you have until April 15 of the following year to withdraw your contribution without penalty.

At least once a year, check your beneficiary designation to be sure it is up-to-date, it is clear as to who gets what if there is more than one beneficiary, and that the beneficiary records of the institution which takes care of your account(s) are correct. Your beneficiaries should also be alerted to check the law about inherited IRAs "just in case."

If you have limited funds and have a Health Savings Plan such as a Flexible Spending Account, Health Savings Account or Health Reimbursement Account, consider funding the Health Savings Plan first. Unlike an IRA account, there is no threshold for using money in the account to pay for medical expenses.

NOTE: Be sure to check your beneficiary statements every year. Even if you set up the record correctly and haven't changed your mind about your beneficiary, the financial institution may make a mistake in its records.

For additional information see:

  Edited by: Peg Downey, CFP, NAPFA, Money Plans, Silver Spring, MD

What Is An IRA?

An IRA (individual retirement arrangement) is a personal savings plan that offers tax advantages to set aside money for your retirement or disability. In its simplest form, an IRA can be a savings bank account earning interest or shares in a mutual fund. The account is registered in your name as an IRA account instead of just in your name. 

Why Should I Consider Having An IRA?

IRAs encourage people to save money by offering the following advantages:

  • Depending on the type of IRA and your circumstances, you may be able to deduct some or all of your contributions from your current income for tax purposes.
  • Generally, earnings and gains in an IRA are not taxed until the money is distributed. The idea is that you will have less income and thus a lower tax when you make a withdrawal from an IRA. In some cases, earnings and gains are not taxed at all if distributed according to the rules.
  • The availability of emergency cash. You can always access money in an IRA, no matter what type it is, whenever you want. Thus, cash for emergencies is always available.
  • It is not recommended that you use money in an IRA for emergency purposes unless you have exhausted all your other options. You will be charged penalties if you make a premature distribution in certain circumstances. For a full list of how you can access funds without penalty, see How To Withdraw Funds From An IRA Without Penalty.
  • Assets in a Traditional IRA are protected from creditors. In some states, assets in Roth IRAs are also protected from creditors. (If you are having credit problems, extra funds may better be directed toward paying down your debt instead of contributing to an IRA -- unless you are planning on going on disability and you havecredit disability insurance on the accounts on which you owe money).
  • Investors age 50 and older can make "catch-up contributions" - contributions which exceed the usual plan limits.
  • Money left in an IRA goes to your heirs without probate. While the money in an IRA is included in your estate for estate tax purposes, it goes automatically to your named beneficiary without having to go through probate. All the beneficiary needs to do to obtain it is to present a certified copy of the death certificate to the holder of the account. (See What Happens to the Money If I Die to review what options your beneficiary will have for receiving the funds.)

Eligibility And Rules About Contributing Money To An IRA (In General)

There are different rules about eligibility requirements for setting up a Traditional IRA and a Roth IRA. Likewise, there are different requirements about the amount you can contribute each year depending on your situation. There are also restrictions on the amount of contributions to a Traditional IRA you can deduct.

Both types of IRA have the following in common:

  • Contributions can be made any time during the year. They can even be made the following year before the tax is due.
  • Excess contributions are subject to an excise tax.

When you transfer funds from a Traditional IRA to a Roth IRA, or from an employer sponsored retirement plan to an IRA without incurring tax, it is known as a "Rollover."  Rollover rules must be followed strictly in order to avoid taxation. For information about rollovers, click here

To learn the rules about eligibility and contributions to IRA and Roth IRAs, see: