Individuals may set up a retirement plan that is qualified and allows contributions to the plan to be made with pre-tax dollars. Individuals may also purchase investment products, such as annuities, that allow their money to grow tax-deferred. The money used to purchase an annuity has already been taxed, making an annuity a nonqualified product.


All individuals with earned income may establish an Individual Retirement Account (IRA). Contributions to traditional IRAs may or may not be tax deductible depending on the individual's level of adjusted gross income and whether the individual is eligible to participate in an employer-sponsored plan. Individuals who do not qualify to participate in an employer-sponsored plan may deduct their IRA contributions regardless of their income level. The level of adjusted gross income that allows an investor to deduct IRA contributions has been increasing since 1998. These tax law changes occur too frequently to make them a practical test question. Our review of IRAs will focus on the four main types:

• Traditional . Roth


• Educational


Currently, a traditional IRA allows an individual to contribute a maximum of 100 percent of earned income, or $5,500 per year or up to $11,000 per couple. If only one spouse works, the working spouse may contribute $5,500 to an IRA for him- or herself and $5,500 to a separate IRA for his or her spouse under the nonworking spousal option. Investors over age 50 may contribute up to $6,500 of earned income to an IRA. Regardless of whether the IRA contribution was made with pre- or after-tax dollars, the money is allowed to grow tax-deferred. All withdrawals from an IRA are taxed as ordinary income regardless of how the growth was generated in the account. Withdrawals from an IRA prior to age 59 1/2 are subject to a 10 percent penalty tax as well as ordinary income taxes. The 10 percent penalty will be waived for first-time homebuyers; for educational expenses for the taxpayer's child, grandchildren, or spouse; if the account holder becomes disabled; or if the payments are part of a series of substantially equal payments. Withdrawals from an IRA must begin by April 1st of the year following the year in which the taxpayer reaches 70 1/2. If an individual fails to make withdrawals that are sufficient in size and frequency, the individual will be subject to a 50 percent penalty on the insufficient amount. An individual who makes a contribution to an IRA that exceeds 100 percent of earned income or the annual limit, whichever is less, will be subject to a penalty of 6 percent per year on the excess amount for as long as the excess contribution remains in the account.

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