Important IRA Terms and Considerations

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When it comes to planning for retirement, most financial advisors will say that next to an employer-sponsored 401(k) plan, an Individual Retirement Account (IRA) is your best consideration toward retiring at a reasonable level of comfort. When looking into an IRA, there are several considerations and important IRA terms to keep in mind.

Important IRA Terms

Understanding the Basic Terms

The first important IRA term to understand is what exactly an IRA is. An IRA is an account you establish at your chosen financial institution which enables you to save money for retirement and provides tax-free growth, tax-deferment and in some cases tax-free withdrawal. This means that you won’t be taxed on the money you put in the IRA but rather potentially taxed when you reach an age when you are ready to start withdrawing from it.

Other important IRA terms with which to be familiar include the three main types of IRAs.

  • Traditional IRA. Contributions are potentially deductible on taxes. Money earned from investments is typically tax-deferred until retirement.
  • Roth IRA. Contributions to Roth IRAs are money that you have already paid taxes on and most likely the earnings will be tax-free, including when the money is withdrawn in retirement providing you meet certain qualifications, the most common being that you wait until you are 59 1/2 years old and have been contributing to the account for at least five years.
  • Rollover IRA. Contributions come from rolling over money from an employer-sponsored plan such as a 401(k) or 403(b) into a traditional IRA. In more rare cases, if your employer-sponsored plan is a Roth 401(k) or Roth 4o3(b), it can be rolled over into a Roth IRA. 

All IRAs have great tax benefits, either in the immediate or long-term. When trying to choose which type of IRA is your best option, you may want to consult a “Roth vs. Traditional IRA Calculator” which can be found at many investment websites.

Reasons to Invest in IRAs

When it comes to considering an IRA, the important terms investors usually want to know about next are “the benefits to me.” When defining a “decent” or “comfortable” retirement, most financial advisors would say the average person will need up to 85% of their pre-retirement income. Individual Retirement Accounts can be a good way to get there. Besides the tax-free or tax-deferred growth, there are other advantages to investing in an IRA.

  • If a traditional IRA is chosen, the deferred tax is typically less. The money isn’t usually taken out until retirement. At that point, most people find themselves in a lower tax bracket, which means that the rate of taxes on the withdrawals will be lower.
  • Savings can potentially compound more quickly than taxable accounts such as money market mutual funds.
  • Investors can contribute to an IRA as well as an employer-sponsored 401(k).
  • Compared with employer-sponsored plans, most IRAs provide access to more investment choices allowing for greater diversification. 

Other Important IRA Terms

Once you have decided that an IRA is one of the routes you will choose toward retirement planning–or even if you already have an IRA–there are still other important IRA terms to know.

  • Non-deductible vs. Deductible. These are most likely the first important IRA terms to consider once you’ve decided on an Individual Retirement Account. Contributions are non-deductible to Roth IRAs, but they are deductible for most traditional IRAs. Depending on your filing status and income, traditional IRA contributions may still be deductible even if you already have a 401(k).
  • Adjusted Gross Income (AGI). Used to determine IRA contribution limits. The AGI includes all of your taxable income after deducting such things as moving or business expenses, losses, or contributions to a traditional IRA.
  • Modified Adjusted Gross Income (MAGI). Can also be used to determine IRA contributions. The MAGI is figured by adding back certain items to the Adjusted Gross Income. This can include certain tax breaks, such as qualified educational costs, or other income such as foreign income that wasn’t required for your original AGI.
  • Retirement Plan Contribution Limit. If possible, contribute the maximum amount allowable to your IRA. This amount changes each year. Also at age 55, the limit is higher. Contributions cannot exceed an individual’s earned income.
  • Required Minimum Distribution. Traditional IRAs require individuals to start withdrawing from the IRA by or before the beginning of April the year after turning 70 1/2 years old. The amount of the required distribution will be determined by age and life expectancy. The IRS website can provide tables to assist in calculating the required minimum distribution. Roth IRAs are not subject to this required distribution until death.
  • Rollover. This applies to money reinvested from one tax-deferred retirement plan, such as an employer-sponsored 401(k) plan, to an IRA within 60 days. This allows investors to take advantage of the benefits of an IRA while avoiding potential taxes and penalties. Make sure the transfer is a direct rollover from the trustee of the previous plan to the trustee of the IRA (as opposed to having the money distributed to you first) to avoid mandatory tax withholdings.
  • Tax-free and Penalty-free Withdrawals. Money can be withdrawn early from IRAs once a year without paying penalties or taxes providing the money is paid back within 60 days. However, most financial experts advise against this practice of using the IRA as a 60-day loan source unless in an emergency.