An IRA is an "Individual Retirement Account". The name is somewhat of a misnomer since the account isn't necessarily "individual" by nature. Perhaps this is a great lead in to the arbitrary definition of the "Individual" in "Individual Retirement Accounts". An IRA may be part of an employer-based retirement plan (retirement plans that are only available through your employer) or it may be truly individualized (a retirement account that you take with you regardless of where you work).
A Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) IRA are both examples of employer-based IRAs. A traditional IRA and a Roth IRA are a little more familiar (my guess) since they are standard fare for any decent brokerage house.
IRAs, like 401(k) plans, have arbitrary savings amounts. But, unlike 401(k) plans, the rules are a bit more complex. You may save money in an IRA but the dollar amount depends entirely on what kind of IRA you have.
SEP IRAs limit contributions are limited to $49,000 per year. But, it's not quite that simple (no pun intended). Despite it's name, the simplified employee pension actually has some serious rules that go along with it. The $49,000 annual cap on contributions is made on a pretax basis, but the employer must contribute the dollar amount to the plan. Employers may contribute up to 25 percent of an employee's pay in any given year. This percentage is based on only the first $245,000 of income. But, regardless of that, the percentage is capped at $49,000.
The IRS also specifies more rules for who is eligible:
An eligible employee is an individual who meets the following requirements:
* attained age 21;
* has worked for the employer in at least 3 of the last 5 years;
* has received at least $550 in 2010 and 2011 (subject to annual cost-of-living adjustments in later years) in compensation from the employer for the year.
The employer may use less restrictive requirements to determine an eligible employee.
What is this "3 of 5" rule? I'm glad you asked:
Assume an employer has a SEP with a requirement that an employee must work for it in at least 3 of the last 5 years (the maximum requirement) to receive an allocation under the plan. To be eligible for the 2010 year, for example, an employee must have worked for the employer for some time (no matter how little) in any 3 years in the 5-year period 2005 to 2009. Thus, an employee that worked for the employer in 2005, 2008 and 2009, must share in the SEP contribution made for 2010.
Now, this is just an example of one IRA. The SIMPLE has entirely different rules, complete with different maximum contribution limits (and is equally un-simple). On top of that, traditional and Roth IRAs also have different contribution limits with the Roth IRA being the "odd man out" on how distributions from the IRA work.
For example, a Roth IRA is only allowed to accept non-deductible contributions. This means that all of the money you put into a Roth IRA must be after-tax dollars. You may only put in up to $5,000 though. But, this $5,000 is only the limit if you are under the age of 50. If you're over 50, you may put in $6,000 per year. Withdrawals from your account can only really be made after age 59 1/2 (which is actually consistent with all IRAs). But, there is an exception to this as well. Roth IRAs have different ordering rules than other IRAs. This means that you may withdraw all of your contributions from the Roth IRA at any time prior to withdrawing any investment gains. You can even withdraw these contributions prior to your age 59 1/2 without incurring a penalty or paying income tax on your withdrawal.
If you do withdraw interest gains prior to your age 59 1/2, you pay a 10 percent penalty (OK, that's also consistent across all retirement plans) plus income tax on the gains. If you wait until age 59 1/2, you pay no tax.
BUT
You can skirt all of these rules by making withdrawals under an IRS rule 72(t) exception. There is a provision within rule 72(t) that allows you to make withdrawals from your Roth IRA without a penalty as long as you specify that you are making withdrawals under this rule. The withdrawals must be based on your life expectancy at the age when you start the withdrawals (thus making the withdrawals "equal and substantial" under the IRS's requirements for such withdrawals) and must continue for 5 years or until you reach age 59 1/2 (whichever is longer).
The major drawback to IRA, like 401(k) plans, is that the government arbitrarily dictates when you can save money, when you can't, how much you can save and when you get to use that money and under what terms you get to use it. If you're still sold on the idea, I suggest you brush up on all of the many, many rules contained in IRS publication 590. My experience is that most financial advisers do not disclose all of the facts surrounding these plans and many clients don't ask (and some don't care). It's a recipe for disaster.
This post is part of a series on retirement plans. Want to read more? Here's the rest in the series:
Retirement Plan Rules, Part 1: 401k Plans
Retirement Plan Rules, Part 2: IRAs
Retirement Plan Rules, Part 3: Annuities
Retirement Plan Rules, Part 4: Employer Pension Plans
Retirement Plan Rules, Part 5: A Solution
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This entry was posted on June 25th, 2012 by David. Edits may have been made to keep this entry current. · No Comments · Retirement Planning