One of the most common misunderstood financial planning concepts that we come across when meeting with new clients is the Individual Retirement Account also more commonly known as an IRA. The most common misconceptions we find with respect to IRAs typically are:
1.) That an IRA is a type of investment which earns a certain rate of return and
2.) That one can contribute any lump sum they receive into an IRA.
An IRA is a type of investment account. It is a form of retirement plan provided by many financial institutions that offers tax advantages for retirement savings in the United States as described in IRS Publication 590, Individual Retirement Arrangement (IRAs). Within this type of account one may invest in many different types of investments or simply hold the contributions in cash. Second, depending on the type of IRA, as described below, one is limited to a certain amount which they can contribute to an IRA in a year and which must come from EARNED INCOME and not another asset. For example, many times when someone receives an inheritance, which is outside of an IRA there is the common misconception that they can simply contribute the entire inheritance to an IRA and thereby make it tax deferred. Unfortunately, again IRAs are governed by strict limits as to the annual amounts one can contribute to them and the contribution must come from earned income (with the exception of spouses who can contribute on behalf of their non working spouse if the working spouse has earned income). A brief discussion of the types of IRA follows:
There are several types of IRA:
- Traditional IRA – contributions are often tax-deductible (often simplified as “money is deposited before tax” or “contributions are made with pre-tax assets”), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted). Depending upon the nature of the contribution, a traditional IRA may be referred to as a “deductible IRA” or a “non-deductible IRA.” It was introduced with the Tax Reform Act (TRA) of 1986.
- Roth IRA – contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William V. Roth, Jr. The Roth IRA was introduced as part of the Taxpayer Relief Act of 1997.
- SEP IRA – a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee’s name, instead of to a pension fund in the company's name.
- SIMPLE IRA – a Savings Incentive Match Plan for Employees that requires employer matching contributions to the plan whenever an employee makes a contribution. The plan is similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately.
There is one instance in which a lump sum can be contributed to an IRA (typically a Traditional IRA) and that is when someone is leaving a position where they had an employer sponsored qualified retirement plan such as a 401(k). In this instance the balance of their 401(k) no matter how large can be "rolled" into an IRA (also known as an IRA rollover account) which is then controlled by the individual and not their former company.