Individual retirement arrangements (IRAs) are investment vehicles, established without the backing of an employer, that provide tax-deferral on investments. Contributions to IRAs can be deductible or nondeductible on a current tax return (depending on whether the tax payer is an active participant in an employer-sponsored retirement plan and their modified adjusted income). Both deductible and nondeductible IRA contributions enjoy the benefit of tax-deferred growth until the funds are withdrawn from the retirement account. Similar to distributions from 401(k)s, withdrawals from IRAs are taxed as ordinary income.
IRAs have several advantages over 401(k)s. Both investment vehicles are similar in that they are simply tax deferred accounts, and individual investments must be purchased within these accounts. However, whereas most 401(k)s have a limited number of investment options available, a nearly unlimited number of investments are available within an IRA. Consequently, constructing efficient, diversified portfolios is often more easily accomplished within an IRA.(Note that many financial planners make a living by selling annuities within an IRA. This is not in the client’s best interest because an annuity only provides a benefit that the IRA already provides— tax-deferral. If a financial advisor recommends that you purchase an annuity within your IRA, find a new financial advisor immediately.)
Additionally, investors with a household income of less than $50,000 may receive a tax credit for contributing to their IRA. This tax credit can be as much as 50 percent of the IRA contribution, up to a maximum of $2,000. Also, when you withdraw money from an IRA, you do not have to withhold 20% of the amount for taxes, which is required when you withdraw money from a 401(k) plan.
Yet, IRAs have several disadvantages when compared to 401(k)s. First, investors can’t take advantage of a company match, which is frequently offered in employer-sponsored retirement plans. In addition, IRAs have relative low contribution limits compared to 401(k)s. In 2009, investors can only contribute $5,000 to their individual retirement accounts, and those above the age of 50 can make an additional $1,000 “catch-up” contribution. Lastly, IRAs are not always protected from creditors. Credit protection for an IRA is determined by individual state statutes.
Investors should only contribute long-term investment funds to their IRA. With only a handful of exceptions, funds withdrawn from an IRA before the age of 59.5 will be subject to a 10 percent penalty. Like 401(k) accounts, required minimum distributions are required from IRAs once the investor reaches age 70.5.