An IRA is an Individual Retirement Account, which is an investment account offering long-term tax-advantaged savings. With a self-directed IRA, you manage your own investments, rather than having a bank or mutual fund company direct your plan for you. Beyond that, most IRAs share similar characteristics in terms of the investments they can hold and their tax characteristics.
Investments
Self-directed IRA accounts can hold almost any investment that you might normally purchase in a taxable investment account. Income generated in an IRA is tax-deferred until withdrawal for Traditional IRAs, and is tax-free even upon distribution from a Roth IRA, so this can be used to your advantage when planning your investment portfolio. For example, you may consider placing your interest-bearing investments such as bonds in an IRA, as that money escapes current taxation. Similarly, if you frequently trade stocks, the short-term gains you generate in an IRA are not currently taxable, while they would be taxed at ordinary income rates in a taxable investment account.
Contributions
Contributions to all Traditional and Roth IRAs as of 2010 are limited to the lesser of $5,000 or the amount of your current compensation. If you are age 50 or older, this amount increases to $6,000. If your modified adjusted gross income, or MAGI, exceeds $120,000 as a single filer, or $176,000 if you are married and filing jointly, you cannot contribute to a Roth IRA.
Deductibility
Contributions to your self-directed Traditional IRA are generally tax-deductible if you are not covered by another retirement plan at work. If you are, your deductibility is determined by the amount of your MAGI as specified in IRS Publication 590. Roth contributions are not tax-deductible.
Required Distributions
While you never have to take money out of your Roth IRA, you must begin taking annual distributions from your Traditional IRA once you reach age 70 1/2. Specifically, the IRS mandates a distribution by April 1 of the year after you reach age 70 1/2, and the amount is determined by dividing your account value by your life expectancy. Appendix C of IRS Publication 590 specifies your life expectancy for distributions purposes.
Penalties
If you withdraw funds from your IRA before you reach age 59 1/2, the IRS will impose a 10 percent penalty on the amount of your distribution. If you take money out of a Roth IRA within the first five years after you open the account, you will incur the same 10 percent penalty, plus the earnings on your distribution will be taxable at ordinary income rates. A 50 percent penalty on the amount not withdrawn is charged if you fail to take your required minimum distribution from your Traditional IRA after age 70 1/2.
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