Individual Retirement Accounts (IRAs)
Individual retirement accounts are retirement plans that were introduced in the U.S. to allow individuals to contribute to a retirement account with pre-tax dollars. In other words, individuals can deduct a certain amount of money from their taxable income if they put it into an IRA. Taxes on the contributions and earnings in the account are deferred until the time of withdrawal. At withdrawal, all contributions and earnings are taxed at the individual’s ordinary tax rate. The investment advantage of an IRA is that income that normally would be taken out in taxes can stay in the account and earn additional income. Moreover, many people are at a lower tax rate at retirement than when they make contributions. This type of IRA is called a traditional IRA; we will discuss the Roth IRA later.
The government puts limits on IRA deduction amounts. All contributions must be made only from earned income as opposed to passive income. Earned income typically means wages. Passive income includes dividends, capital gains, interest on securities in a portfolio, rental income, and inherited funds.
Traditional IRA. Traditional IRA contributions are limited to $6,000 per individual for 2020, although an additional $6,000 can be contributed by a working spouse to a spousal IRA on behalf of a non-working spouse. The government also allows persons age 50 and older to contribute an extra $1,000 as a catch-up contribution.
If an individual is participating in another qualified retirement plan, such as a 401(k), he can open an IRA and make contributions up to the limit. He will not be able to deduct the full amount when calculating federal income taxes, however; the deduction amount will depend on the individual’s income level.
Only cash or cash equivalents can be deposited into an IRA. But once in the account, the funds can be used to buy most kinds of securities and some non-securities. Collectibles, such as works of art and stamps