3 Types of IRAs

IRA stands for Individual Retirement Arrangement. An IRA is a provision of the tax code under which you arrange individually (as opposed to through a group) for your retirement. An IRA, therefore, is not an investment, but simply money the tax code treats differently from other money.

Think of an IRA as a bucket. If you put money into the bucket, you can use that money and sell investments as you wish and, provided the money stays inside the bucket for the required length of time (which varies with each IRA; details will follow), you won’t have to pay taxes that year on the profits you earn.

It’s important to emphasize that you can buy almost any investment you want with your contribution: CDs, money markets, stocks, bonds, mutual funds—almost anything, provided that any asset you buy stays in the bucket. You also may sell at any time any investment you previously bought, and replace it with something else, provided all the transactions occur—and the proceeds stay—in the bucket. You will pay no taxes until you withdraw money from the bucket. That’s all there is to it.

Here are the three main types of IRAs.

Deductible IRAs offer two major benefits:

• You do not pay taxes on the money you contribute until you make a withdrawal.
• Any interest, dividends or capital gains that accumulate in the plan also are tax-deferred until withdrawal.

Thus, by contributing to a Deductible IRA, you get a tax break this year. Plus, the profits grow tax-deferred, and you’ll pay taxes on the account in the future.

Many Americans are not eligible to contribute to a Deductible IRA due to income limits. For many of these people, an option is the Non-Deductible IRA. As the name suggests, contributions do not entitle you to a tax deduction. All this raises a question: If you are not permitted to contribute to the Deductible IRA, should you contribute to the Non-Deductible IRA, assuming that you’re eligible? No.

If you cannot deduct your contribution yet make one anyway, you must file IRS Form 8606, Nondeductible IRAs (Contributions, Distributions and Basis) every year you add to or make a withdrawal from an IRA. This form tells the IRS that you already paid taxes on a portion of the money that you had contributed to the IRA.

What happens if you don’t file the form, or if you file but fail to keep a record of it for the rest of your life? There is a $50 penalty for failing to file, and if you don’t keep your records in order, you’ll have to pay taxes when you withdraw the money—even though you already paid taxes when you contributed to the IRA years earlier. Indeed, you’ll pay taxes twice on the same money!

This is the newest IRA, created by Congress and named for William Roth, then US Senator from Delaware who sponsored the legislation.

Like the Non-Deductible IRA, you don’t get a current tax deduction when making contributions, but unlike the Deductible and Non-Deductible IRAs, withdrawals from the Roth IRA will be completely tax-free, provided:

• You leave the money in the account for at least five years after making the first contribution
• You reach age 59 1/2 (with exceptions for such events as death or disability)

Also, unlike Deductible and Non-Deductible IRAs, both of which require you to begin making withdrawals by age 70 1/2 and prevent further contributions after that age, the Roth IRA has neither restriction.

Ric Edelman is Founder and Executive Chairman of Edelman Financial Services, LLC, a Registered Investment Advisor, and an Investment Advisor Representative who offers advisory services through EFS and is a Registered Representative and Registered Principal of, and offers securities through, EF Legacy Securities, LLC, an affiliated broker/dealer, member FINRA/SIPC.

From the book The Truth About Money (Fourth Edition) by Ric Edelman. Copyright ©1996, 1998, 2000, 2004, 2010 by Ric Edelman, Edelman Financial Services LLC Reprinted by permission of Harper Business, an imprint of HarperCollins Publishers.