Individual Retirement Accounts (IRAs) were set up by the U.S. Government in the early 1970’s. IRAs were given two main benefits to incentivize people to use them. First, was a tax deduction; any contribution – up to the maximum of $2,000 (at the time) – could be deducted from current year’s taxable income. The second—and many say main—benefit, is tax deferral. This allows all earnings to compound and grow without capital gains taxation until the money is withdrawn; at which time it is taxed as ordinary income. This allowed for the potential earnings to compound more rapidly than if the account was subject to taxes year after year; potentially resulting in a larger retirement nest egg. Due to the current year tax deduction, many people who first opened IRA accounts did so on the advice of their Tax Professional.
Of course, the government requires adherence to some rules to get these benefits, which can change from year to year. Today there are higher maximum contributions allow you to save more, reflecting today’s longer life expectancies and there are new rules about whether or not you can deduct your contributions based on your income level and if you or your spouse have a plan offered to you by your employer. Generally, all contributions and earnings must be left inside the IRA until reaching the age of 59 1/2 in order to avoid premature distribution penalties. IRA participants are required to start making distributions in the year after you reach the age 70 1/2. Failure to take required minimum distributions (RMD) can result in significant tax penalties.
One of the primary uses of IRAs today is to accept a rollover of corporate retirement plans when you leave an employer. Use of an IRA in this manner allows you to continue the benefits of tax deferral when you leave your employer while controlling your investment options directly. IRAs are one type of retirement savings options.