IRA stands for Individual Retirement Account, which is a method of saving money for retirement that is aided by receiving tax breaks from the federal government. The type of tax break an individual receives is determined by the type of IRA he opens.
Types
Although there are many different types of IRAs, the most common are the Roth IRA and the traditional IRA. Two other fairly common types of IRAs are the Simplified Employee Pension IRA, or SEP IRA, and the Savings Incentive Match Plan for Employees, generally referred to as the SIMPLE IRA. With a SIMPLE IRA, employers will make contributions into your IRA, and you have the option of making contributions yourself through payroll deductions. SIMPLE IRAs are typically limited to businesses with 100 or fewer employees. An SEP IRA is entirely funded by the employer, who will make direct deposits into the employee's IRA. These types of IRAs are open to any size business.
Benefits
The key to the difference between a Traditional IRA and a Roth IRA is found in when they receive tax benefits. The contributions made to a traditional IRA are often tax deductible, but taxes are paid on withdrawals. Contributions to a Roth IRA are not tax deductible, but withdrawals are not subject to taxation.
Significance
Both the traditional IRA and the Roth IRA have some type of income limitation. In 2010, you will be excluded from opening a Roth IRA if your modified adjusted gross income exceeds $120,000, and you file your federal taxes as single. Married couples who file jointly will be excluded from opening a Roth IRA if their combined modified adjusted gross income exceeds $176,000. Your income will not exclude you from opening a traditional IRA, but you will not be eligible to claim your contributions on your 2010 taxes if your adjusted gross income is greater than $109,000 for those married and filing a joint return. The maximum adjusted gross income for a single person to be able to deduct their traditional IRA contribution is $66,000. Participation in an employer-run retirement plan could also affect your eligibility to deduct your IRA contributions from your taxes.
Function
As IRAs are intended to be retirement savings, you will not be able to withdraw the money from your IRA until you reach age 59.5 without suffering a 10 percent penalty. A Roth IRA also requires you to keep the money in the account for five years before making a withdrawal, or suffer the 10 percent penalty. There are several allowances for early withdrawals without penalty, such as $10,000 for a first-time home buyer, if you become disabled or in the event of death of the account holder.
History
The IRA came into existence in 1974 and at first was solely for individuals who were not enrolled in an employer-sponsored retirement program. In 1981 the law was changed to allow anybody under 70.5 to participate in an IRA. The Roth IRA was established in 1997.
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