If you were to ask the IRS, the term IRA refers to Individual Retirement Arrangements, which can take the form of Individual Retirement Annuities or Individual Retirement Accounts.  The latter vehicles are what people typically refer to when they use the term “IRA”.  The IRA was created by Congress in 1974 to encourage individuals to save for retirement.  Prior to that, the only formal retirement accounts that existed were pension plans that were set up by some companies to help ensure a comfortable retirement for their employees.  People saved and invested, of course, but there was no particular tax incentive to prepare for retirement before 1974. 

The IRA has undergone some changes since it was created, and there are now several flavors of IRA that exist in the marketplace.  In this post, we’ll focus on traditional Individual Retirement Accounts.  These IRAs are the most direct descendant of the original act.  They allow individuals to set aside money each year that will grow on a tax-deferred basis until it is withdrawn after the age of 59½.

Deductibility

Under certain circumstances, the contributions to a traditional IRA are deductible on the contributor’s federal tax return.  If neither you nor your spouse is covered by a plan at work, the full amount of your contribution can be deducted from federal taxes in the year that it is made.  If you are covered by a retirement plan at work, you may still deduct contributions if you are single and your income is below $55,000.  If you’re married filing jointly, the threshold is $89,000.  In both cases, the deductibility phases out as income increases from those levels.

Contribution limits

For 2009 and 2010, taxpayers can contribute a maximum of $5,000 to their traditional IRA.  For those aged 50 and above, the limit is $6,000.

Taxes at withdrawal

In all cases, taxes will be paid on the investment earnings that have accumulated over time when those earnings are withdrawn.  If a deduction was taken for a given contribution, that contribution is subject to taxes.  If a deduction was not taken for a contribution, the amount of that contribution can be withdrawn without paying tax, because taxes have already been paid on those funds. 

When can funds be withdrawn?

As I alluded to earlier, funds can be withdrawn without penalty beginning at age 59½.  However, it is not mandatory to withdraw funds until the accountholder turns 70½.  These mandatory withdrawals are referred to as Required Minimum Distributions, and are designed to allow the IRS to start capturing tax revenue on the investments that have been enjoying tax deferral for so many years.  They are based on the investor’s remaining life expectancy, with the idea being that distributions will be taken evenly over the remaining years.  In a future post, I’ll demonstrate how the RMD is calculated.