Legal Definitions - individual retirement account (IRA)

The term Individual Retirement Account (IRA) refers to a personal savings plan that allows individuals to save for retirement with significant tax advantages. Unlike employer-sponsored retirement plans like a 401(k), an IRA is opened and managed directly by the individual through a bank or investment firm.

There are two main types of IRAs, each offering different tax benefits:

• Traditional IRA: Contributions to a Traditional IRA may be tax-deductible in the year they are made, meaning they can reduce your current taxable income. The money invested grows tax-deferred, which means you don't pay taxes on the investment gains until you withdraw the funds in retirement.
• Roth IRA: Contributions to a Roth IRA are made with after-tax money, meaning they are not tax-deductible. However, the money grows tax-free, and qualified withdrawals in retirement are also completely tax-free.

Both types allow your investments to grow over time, helping you build a nest egg for your later years. The Internal Revenue Service (IRS) sets annual limits on how much an individual can contribute to an IRA. Generally, funds can be withdrawn without penalty once the account holder reaches age 59½, or under specific circumstances like disability. Early withdrawals before this age typically incur a penalty in addition to regular income taxes. For Traditional IRAs, individuals usually must begin taking Required Minimum Distributions (RMDs) once they reach a certain age, typically 72, unless they are still working. Roth IRAs do not have RMDs for the original owner.

It's important to note that eligibility to deduct Traditional IRA contributions or to contribute to a Roth IRA at all can be subject to income limitations, especially if you or your spouse also participate in an employer-sponsored retirement plan.

Examples of Individual Retirement Accounts (IRAs) in practice:

• Freelancer Saving for Retirement: Sarah is a freelance graphic designer who works for herself and does not have an employer offering a 401(k) plan. To save for her retirement, she opens a Traditional IRA at an investment firm and contributes the maximum allowed each year. Her contributions are tax-deductible, reducing her current taxable income, and her investments grow without being taxed annually until she withdraws them in retirement. This illustrates how an IRA provides a personal retirement savings vehicle with tax benefits for individuals who do not have access to employer-sponsored plans.

• Young Professional Planning for Future Tax-Free Income: David is 28 years old and has just started his career. He anticipates that his income will increase significantly over his working life, potentially placing him in a higher tax bracket in retirement. He decides to open a Roth IRA and contribute regularly. David chooses a Roth IRA because by paying taxes on his contributions today, he ensures that all his qualified withdrawals in retirement, including all the investment growth, will be completely tax-free. This demonstrates how a Roth IRA can be advantageous for those who expect to be in a higher tax bracket in retirement than they are currently.

• Supplementing an Employer's 401(k): Maria works for a large corporation and already contributes to her employer's 401(k) plan. However, she wants to save even more for retirement beyond what her 401(k) allows or offers in investment choices. She opens a Traditional IRA. Depending on her income, her contributions might not be tax-deductible because she also participates in a 401(k), but she still benefits from the tax-deferred growth of her investments. This shows how an IRA can serve as an additional tool for retirement savings, allowing individuals to save more or diversify their investments beyond what their employer-sponsored plans offer, while still enjoying tax advantages.