An Individual Retirement Account is a long-term, tax-advantaged savings account. The main types of personal IRAs are Roth IRAs and Traditional IRAs. If you want an investment manager to make your investment choices for you, you can open an IRA at a bank or mutual fund company. However, if you want to make all of your own investment decisions, you can open a self-directed IRA at a brokerage firm.
Self-Directed IRAs
All IRA accounts, including self-directed IRAs, require the services of a custodian who performs administrative functions for the account such as filing required tax documents. The term "self-directed IRA" refers only to the investment management of the account, not the administration of the account. In all other aspects, such as contribution limits and taxation characteristics, a self-directed IRA is the same as any other personal IRA.
Contributions
Contributions to a self-directed IRA must be made by your annual tax filing date, usually April 15 unless you file an extension. For 2010, the Internal Revenue Service limits contributions to Traditional and Roth IRAs to $5,000, or $6,000 if you are age 50 or older. However, if you have a modified adjusted gross income above certain limits, you are not allowed to contribute to a Roth IRA. This MAGI limit is modified annually, as reported in IRS Publication 590.
Deductibility of Contributions
Contributions to a Roth IRA are made on an after-tax basis, meaning the money you deposit has already been taxed, and you will not receive a tax deduction for making a contribution. A Traditional IRA is a pre-tax vehicle, meaning you can take a deduction on your contributions, subject to applicable IRS restrictions. Deductibility regulations can get complicated, but essentially you can deduct the full amount of your Traditional IRA contribution if you are not covered by another retirement plan at work. If you are covered by an employer-sponsored plan, your MAGI helps determine the deductibility of your contribution. The IRS provides a matrix of deductibility in IRS Publication 590.
Taxation
Distributions from a Traditional IRA are typically fully taxable at ordinary income tax rates. However, earnings in the account are tax deferred until taken out of the account. Roth IRA withdrawals are usually tax free, unless they are taken within five years of the establishment of the account. Earnings growth in a Roth IRA is tax free.
Required Minimum Distributions
For Traditional IRAs, the IRS requires that you begin taking annual minimum distributions no later than April 1 after you turn 70 1/2. The amount of the distribution is calculated by dividing your year-end account balance by your life expectancy, as determined by Appendix C of IRS Publication 590. Roth IRAs have no required minimum distributions at any time.
Penalties
Distributions from an IRA before the age of 59 1/2 are subject to a 10-percent IRS early withdrawal penalty, except for withdrawals due to disability, higher education expenses, excess medical expenses and a few other exceptions outlined in IRS Publication 590. If you take a distribution from a Roth IRA within five years of its inception, the withdrawal incurs a 10-percent penalty, and the earnings you withdraw are subject to ordinary income tax.
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