Legal Definitions - individual retirement account

An Individual Retirement Account (IRA) is a personal savings plan that allows individuals to save for retirement with tax advantages. The specific tax benefits depend on the type of IRA chosen, but generally involve either tax-deductible contributions (reducing current taxable income) or tax-free withdrawals in retirement.

There are several common types of IRAs, each with distinct features:

• Traditional IRA: This type of IRA allows individuals to contribute a specified amount of earned income each year. Contributions may be tax-deductible, meaning they can reduce your taxable income in the year they are made. The money in the account, including any investment earnings, grows tax-deferred, meaning you don't pay taxes on it until you withdraw it in retirement. Withdrawals made before age 59½ are typically subject to a 10% penalty, in addition to regular income tax.

  • Example 1: Sarah, a 40-year-old marketing manager, contributes $6,500 to her Traditional IRA. Because her income falls within the IRS guidelines, she deducts this contribution from her taxable income for the year, reducing her current tax bill. The funds she invested within the IRA grow over the next two decades without being taxed annually, allowing her investments to compound more effectively until she retires.

    Explanation: This illustrates how a Traditional IRA can provide an upfront tax deduction and tax-deferred growth, meaning taxes are postponed until retirement withdrawals.

  • Example 2: When David leaves his job at a tech company, he decides to roll over his old 401(k) retirement plan into a Traditional IRA. This allows him to maintain the tax-deferred status of his retirement savings without incurring immediate taxes or penalties, and gives him more control over his investment choices than his old employer-sponsored plan.

    Explanation: This demonstrates how a Traditional IRA can be used to consolidate and continue the tax-deferred growth of retirement savings from other plans, like a 401(k).

• Roth IRA: Unlike a Traditional IRA, contributions to a Roth IRA are made with money that has already been taxed (they are not tax-deductible). However, the significant advantage of a Roth IRA is that qualified withdrawals in retirement—after age 59½ and after the account has been open for at least five years—are completely tax-free. This means you pay no taxes on your contributions or any investment earnings when you take the money out.

  • Example 1: Maria, a 28-year-old graphic designer, believes that tax rates will be higher when she retires in the future. She contributes to a Roth IRA, knowing that while she doesn't get a tax deduction now, all her withdrawals in retirement will be tax-free, regardless of how much her investments have grown.

    Explanation: This highlights the key benefit of a Roth IRA: tax-free withdrawals in retirement, which is particularly appealing to those who anticipate higher tax rates later in life.

  • Example 2: John, a recent college graduate, starts his first full-time job and immediately opens a Roth IRA. He contributes a small portion of his after-tax paycheck each month. Even though his current income is relatively low, he values the ability to access his contributions tax-free and penalty-free at any time (though earnings still have rules), and the prospect of completely tax-free growth for his retirement.

    Explanation: This illustrates how a Roth IRA can be a valuable tool for young savers, providing tax-free growth and some flexibility with contributions, while setting them up for tax-free income in retirement.

• Coverdell Education Savings Account (ESA): Formerly known as an Education IRA, a Coverdell ESA is a trust or custodial account set up to pay for a student's qualified education expenses. Contributions are not tax-deductible, but the earnings grow tax-free, and withdrawals are also tax-free if used for eligible education costs, including expenses for K-12 schooling and higher education.

  • Example 1: The grandparents of young Emily contribute to a Coverdell ESA for her. Over the years, the money grows tax-free. When Emily attends private middle school, her parents use the funds from the ESA to pay for her tuition, books, and school supplies, and these withdrawals are completely tax-free.

    Explanation: This shows how a Coverdell ESA can be used by family members to save for a child's K-12 education expenses, with the benefit of tax-free growth and withdrawals.

  • Example 2: Mark and Lisa are saving for their son Alex's college education. They contribute annually to a Coverdell ESA. When Alex enrolls in a state university, they withdraw funds from the ESA to cover his tuition, room and board, and required fees. Because these are qualified education expenses, the withdrawals are not subject to federal income tax.

    Explanation: This illustrates the use of a Coverdell ESA for higher education expenses, emphasizing the tax-free nature of withdrawals when used for eligible costs.