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June 2001

Q. IRAs are apparently a key part of retirement planning. What exactly is an IRA, and what are the benefits of having one? Where do I go to get started?

A. IRA stands for Individual Retirement Account. An IRA is a personal savings plan that allows you, or sometimes your employer, to save and invest money that will be used during your retirement. In most cases, an IRA provides tax advantages unavailable through a traditional savings account or other investment vehicle. In general, you can contribute up to $2,000 per year into your IRA and often deduct a portion of your contribution from your taxable income. You then direct those funds into a number of investment vehicles, usually after consulting with a financial planner. The money you contribute, as well as the earnings and gains from these contributions, accumulates tax-free until you withdraw the money from the account. You therefore enjoy the ability to generate additional earnings, unreduced by taxes, each year the funds remain in the IRA.

There are four kinds of IRAs that can be established for retirement purposes (there is also one that assists with savings for higher education, for which the term “IRA” is a bit of a misnomer). They include the traditional IRA, the Roth IRA, the Simplified Employee Pension (SEP) IRA, and the Simple IRA (SIMPLE). The traditional IRA and the Roth IRA are those opened directly by individuals. The SEP IRA and SIMPLE are employer-sponsored accounts, but may be of interest if you are self-employed. You can also hold multiple IRAs through different organizations. Here we will introduce the traditional IRA and the Roth IRA, but be sure to work with your financial planner in choosing the IRA that is right for you.

The traditional IRA: Any individual can open and make contributions to a traditional IRA, as long as you or your spouse (if you file a joint return), received taxable earned income during the year and were not 70 ˝ years old by the year’s end. You can contribute up to $2,000 per year. The amount of your contribution that is tax deductible depends on your filing status (Single, Joint, etc.) and your Adjusted Gross Income (AGI). Your contributions may range from fully deductible to totally non-deductible.

The government expects you to begin withdrawing funds from the traditional IRA between age 59˝ and 70˝. The withdrawals, or “distributions,” will be taxed, generally for the year in which you receive them. You may withdraw funds before age 59˝, but they will be subject to taxation and a 10 % penalty, unless certain exceptions apply. In many cases, the penalty can be avoided with proper planning, but professional advice is essential. A stiff penalty also applies if you fail to make minimum withdrawals after age 70˝. Government rules regarding these minimum distributions are among the most complex of the Internal Revenue Code. The penalty is 50% of the shortfall between what you should have withdrawn and the amounts you actually withdrew by the proper date.

The Roth IRA: Contributions to Roth IRAs are subject to income limitations. As of December 2000, the maximum yearly contribution that can be made to a Roth IRA is phased out for a single taxpayer with an AGI between $95,000 and $110,000, for joint filers with an AGI between $150,000 and $160,000, and for people who are married, filing separately with an AGI between $0 and $10,000. Contributions are not tax deductible when the funds are contributed, but the Roth IRA earnings accumulate tax-free and remain tax-free upon distribution. There are also no minimum distribution requirements for the Roth IRA, which means you can leave funds in your account for as long as you live. You also can contribute to your Roth IRA after age 70 ˝, which you cannot do with a traditional IRA. You cannot withdraw your funds during the first five years of your account without a penalty, but this five-year period may be addressed by proper tax planning. Every qualified taxpayer should discuss the establishment of a Roth IRA with his or her financial planner.

You can open an IRA at any organization approved by the IRS. This includes many financial institutions such as mutual fund or stock brokerage firms, insurance companies, banks, savings and loan associations, and federally insured credit unions. The specific investment vehicles available for your IRA funds depend on the organization you choose. It takes a written document to open your IRA, and it must be done in the United States. There may or may not be a fee. Some plans charge nothing, while others charge $10 per fund or $35-60 per account, or more. Each has different services and benefits; find out specifically what they offer and then determine which plan is best for you.

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