An IRA is a tax-deferred savings plan available to anyone who is employed or who receives alimony. IRA contributions are saved in a special account at a financial institution, which serves as the custodian or trustee. Most people are eligible to deduct their total IRA contributions from their income taxes. With an ordinary IRA all or some of the contributions and all of the earnings grow tax free until withdrawal. Those who earn too much to make deductible contributions can protect earnings from taxation by opening a Roth IRA or if income is even higher by opening a nondeductible IRA. With a Roth IRA, contributions are not deductible but earnings are tax free if certain conditions are met. With a nondeductible IRA, contributions are not deductible but the earnings grow tax free until withdrawal. The questions and answers that follow provide information to enable you to use one of these IRAs to your best advantage.

Your IRA Choices 

Traditional IRAs were the main type of IRA used before 1998. Contributions may or may not be deductible, depending on your income, your tax filing status, and whether you take part in a qualified retirement plan. Traditional IRA accounts grow tax-deferred until you begin withdrawing the money. 

You may fully deduct up to $2,000 in IRA contributions if you are not covered by an employer-sponsored retirement plan. This deduction is available to most people even if the spouse is covered by an employer plan. Only when a married couple's adjusted gross income (AGI) reaches $150,000 is your ability to deduct your IRA phased out. (If your spouse is covered by an employer plan and you file separately, your IRA deduction is phased out between $0 and $10,000 AGI.) 

If you are covered by an employer-sponsored plan, deductibility is based upon adjusted gross income (AGI). These AGI limits are gradually increasing and will continue to increase until the year 2007. By that year, joint filers may fully deduct an IRA unless their income is more than $80,000. (Refer to the charts on pages 5 and 6.) 

Earnings and any untaxed contributions are taxed as ordinary income at your highest marginal tax rate when you take withdrawals. You may begin your retirement distributions when you are age 59½. You must, by law, start to take withdrawals no later than the year after you turn age 70½. 

If you withdraw money from an IRA before retirement age, you will probably pay taxes plus a 10% penalty. You can avoid this penalty in some situations. Exceptions to the 10% penalty rule include the following: 

• death of the IRA owner, 
• disability, 
• periodic payments, 
• certain medical expenses, 
• qualified higher education expenses, and 
• a qualified first-time home purchase. 

Spousal IRA is for a spouse with little or no earned income and no retirement plan at work. You may contribute up to $2,000 to IRAs for both the earner and spouse ($4,000 total) as long as this amount is not more than total earnings for the year. The spouse using a spousal IRA may deduct these contributions, up to $2,000 a year, if the earner does not have a retirement plan at work. Even if the working spouse has an employer retirement plan, the spousal IRA deduction is not phased out until AGI falls between $150,000 and $160,000. If you file income taxes separately or if you are covered by an employer plan, your deduction is phased out at lower income levels. (Refer to the charts on page 5 for the deduction limits.) 

With a Roth or Back-loaded IRA, contributions are not tax-deductible. However, qualified distributions from a Roth are not included in income at all. To be qualified, you must have held the Roth IRA for at least five years plus meet one of the following requirements: 

• Distribution made on or after you reach age 59½; 
• Distribution made to a beneficiary (or estate) on or after death; 
• Distribution made because you become disabled; or 
• Distribution to pay "qualified first-time home buyer expenses." This category of distribution is limited to a total of $10,000 during your lifetime. 

The 5-year required time period begins with the first tax year a Roth contribution was made for your benefit. Earnings within your Roth IRA are tax free to you and your heirs if handled properly. 

You may contribute up to $2,000 per year to a Roth even if you have an employer retirement plan unless your income reaches a certain limit. When income reaches $150,000 (married filing joint) the ability to use a Roth is gradually phased out. It phases out completely at $160,000 (married filing joint) in income. For married filing separate, the phase-out range is from $0 to $10,000. For all other the phase-out range is $95,000 to $110,000. These phase-out ranges are not adjusted yearly for inflation. 

You cannot contribute $2,000 to both a Roth and a traditional IRA regardless of income or other retirement plans. Your total IRA contribution for yourself in any given year is limited to $2,000. 

Many traditional IRA account holders wonder whether "to Roth or not to Roth?" This simply refers to your option to convert a traditional IRA to a Roth IRA. You may convert a traditional IRA to a Roth IRA if your adjusted gross income is less than $100,000 (not including the rollover amount). You'll owe taxes on any deductible contributions and investment earnings. If married, you must file jointly to convert IRAs to Roths in that year. You must keep rollover Roth IRAs separate from traditional IRAs. Distributions are considered to be made from contributions first, then converted amounts, and then earnings on the money in the Roth IRA. Unable to find answers to Roth questions? Remember, when there is no specific Roth IRA rule, the rules for traditional IRAs apply. 

Education IRAs are a trust or custodial account specifically to pay for future higher education of a child. Parents, friends, and grandparents can make non-deductible contributions of up to $500 per child (age 0 to 18) per year. If you make more than $95,000 as an individual filer or $150,000 as joint filers, your Ed IRA contribution limit is lower. The Ed IRA benefit is phased out when AGI is between $95,000 and $110,000 for individual filers and between $150,000 and $160,000 for joint filers. 

You can't contribute to both an Ed IRA and a qualified state tuition program for the same child during any one year. 

Withdrawals are tax-free if used for qualified higher education expenses. You must withdraw all the money by the time the child is age 30, or the investment return on the education IRA will be included in the child's taxable income, and a 10% penalty will apply. Unused portions can be rolled over into another family member's education IRA, including grandchildren. An education IRA cannot be used in the same year when the Hope Credit or Lifetime Learning Credit is used. Note that money in a child's name could limit eligibility for college aid. 

IRAs as Part of an Employer-Sponsored Retirement Plan 

If you are you self-employed or if you work for an employer who offers an SEP (Simplified Employee Pension) or SIMPLE Plan to employees, you may be able to put even more money into your IRAs. 

The SIMPLE IRA offers businesses with 100 or fewer employees an affordable way to offer retirement benefits through employee salary reductions (up to $6,000 a year) and matching contributions. 

The SEP IRA (Simplified Employee Pension) is an easy, low-cost retirement plan for employers and self-employed individuals. As a business owner, you can make contributions to your IRA and the IRAs of your employees, up to as much as 15% of their pay.  

Who can contribute to an IRA?

Anyone with earned income or alimony can contribute to an IRA. Deductible contributions depend upon income combined with a qualified retirement plan at work. A qualified pension plan meets Internal Revenue Service requirements and allows the employer to deduct contributions. Federal, state, and corporate pensions, tax sheltered annuities (403(b) plans), 401(k) plans, profit sharing plans, and Keogh plans all count as pensions. When income is high enough, participation in a qualified plan causes the IRA deduction to disappear. On the other hand, if one has no pension plan at work, fully deductible contributions are allowed at any income level. Additionally, if one spouse has a work-related pension and the other working spouse does not, the spouse without a pension plan may make a deductible contribution subject to joint adjusted income limits of $150,000, phasing out at $160,000.

How much can I contribute to my IRA each year?

Workers can contribute up to $2,000 annually per individual from earned income and alimony income to an IRA. If less than $2,000 is earned, a worker can only contribute the amount actually earned from wages or alimony. For example, if you earn $875, $875 is the maximum contribution allowed. A married couple with two earners or a couple with only one earner can contribute up to $4,000 annually with a maximum of $2,000 going to each account. A married couple with only one spouse having a pension at work can contribute up to $2,000 to a spousal IRA for the spouse without a pension if their income does not exceed $150,000. The deduction is phased out at $160,000. If the couple does not file a joint return, the deductible income limit is $10,000. If only part of the maximum can be contributed on a deductible basis, the remainder can be contributed to a Roth IRA or nondeductible IRA. Contributions to an ordinary or nondeductible IRA can continue until the year before you reach age 70 1/2.

How much of my IRA contributions can I deduct from my income taxes?

Deductible contributions provide you with tax savings because you do not have to pay taxes on the amount contributed. For example, if you are in a 15 percent income tax bracket and you contribute $1,000 to an IRA, you do not pay taxes on your $1,000 contribution. You will reduce your taxes by $150 ($1,000 X 0.15 = $150). In other words, the real cost of your IRA is only $850. Individuals in the 28 percent income tax bracket will save even more. The same $1,000 contribution will cost them only $720. Additionally, when your IRA contributions are deductible, you can increase your take-home pay by increasing the number of withholding exemptions on your W-4 form. Increasing your deduction prevents the government from holding your money without the payment of interest.

Fully tax-deferred IRA contributions are available to workers who do not have access to a pension plan. (If you do not have a pension plan, the pension box on your W-2 form will be blank.)

Anyone with earned income and within the income limits can open a Roth IRA. Contributions are made with after-tax dollars. If you withdraw earnings from your Roth IRA within the first five years, they are taxable. Previously taxed contributions can be withdrawn at any time without penalty. Once the IRA is five years old, there is no tax penalty for a withdrawal of earnings if you are at least age 59 1/2, or you are making the withdrawal for one of the reasons discussed below. Withdrawals of earnings for other reasons before age 59 1/2 or before the end of five years are subject to a 10 percent penalty as with other IRAs. The five-year period begins with the year of the first contribution. Contributions can be made as long as you are working. Unlike ordinary or nondeductible IRAs, contributions are allowed after you reach age 70 1/2. The normal IRA distribution rules applicable after age 70 1/2 do not apply to the Roth IRA.

Both you and your surviving spouse can withdraw funds from your Roth IRA or leave the funds intact until both of you have died. After the death of both of you, your heirs must remove funds from a Roth IRA based on the heirs' life expectancy using the term-certain withdrawal method. Term-certain means that one year is subtracted from life expectancy each year as opposed to recalculating life expectancy, which yields a withdrawal of less than one each year.

The Roth IRA does best for those who are 30 years old, because it allows withdrawals over the retirement years of over $1.3 million. At age 65, the deductible IRA has a larger balance because tax savings were reinvested in a taxable account and added to the balance along with earnings.

Ideally, you should contribute to your IRA as early in the tax year as possible. This allows the account to earn the greatest return during the year. However, you can make contributions throughout the year until April 15 of the following year. If you delayed making a contribution for the previous year, you must submit a written statement to the custodian of your IRA indicating that the contribution is for the preceding year, otherwise the contribution will be applied to the present year. To credit the contribution for the previous year, the letter must be postmarked by April 15. If there is a possibility that your check will not be delivered before the deadline, use certified or registered mail and retain the receipt for proof of the postmarked date.

Your IRA custodian will place your contributions in the savings vehicle you choose. Carefully select where you invest your IRA. Your investment may be made in anything except life insurance and collectibles, such as stamps and antiques. Although many IRAs are invested in banking institutions, at times these institutions' interest rates are very low, causing your funds to grow slowly. To learn more about savings at a bank, request Fact Sheet 693, "Savings Basics," from your county Extension office.

You may want to start your IRA at a banking institution. However, when your account grows to $4,000 or $5,000, you may want to invest half of your funds in mutual funds or other investments that can provide a greater return than interest-bearing accounts. However, the risk of loss of principal will be greater because other types of investment are not insured. To learn more about mutual funds, request Fact Sheet 656, "Mutual Funds," from your county Extension office.

Another IRA investment option is a self-directed custodial or trust account at a brokerage firm. Self-directed accounts allow you to purchase stock, bonds, real estate investment trusts, zero-coupon bonds, and unit trusts, as well as mutual funds. Although municipal bonds are allowed as an IRA investment, they are not taxable whether in an IRA or non-IRA account, and the interest is usually at a lower rate than taxable bond interest. To leam more about these investments, request Fact Sheet 694, "Investment Basics," from your county Extension Office.