Individual Retirement Accounts (IRAs)

The Congress created individual retirement accounts in 1974 to benefit people who were not covered by an employment-based retirement plan. Since then, it has restructured them several times (see The Legislative History of IRAs). Currently, almost anyone who has earned income or whose spouse has earned income may participate in an IRA--the only exceptions are certain people older than 70½ who have high incomes. There are two types of IRAs that individuals may establish independent of their employers:(1)

  • Traditional accounts--contributions may be either deductible or nondeductible, and earnings accrue tax-free; however, withdrawals in excess of nondeductible contributions are taxable.

  • Roth accounts--contributions are nondeductible, but earnings accrue tax-free, and all withdrawals are tax-exempt.(2)

Each type of IRA receives favorable tax treatment, the benefits of which depend in large part on the account owner's tax rates while in the workforce and after retirement.

Eligible individuals establish IRAs through financial institutions. The law imposes no limit on the number of accounts a person may hold--multiple traditional accounts or a combination of traditional and Roth accounts are common--but it does restrict total annual IRA contributions (other than rollovers from qualified retirement plans) to $4,000.(3) Whether a person is eligible to contribute to a Roth IRA depends on his or her income. Eligibility to deduct contributions to a traditional IRA also depends on income, unless neither the taxpayer nor his or her spouse is covered by an employment-based plan.

Once participants have contributed funds to an account, they may invest those funds in any instrument that the selected financial institution handles. If participants become dissatisfied with their choices, they can roll their IRA over into an account at another financial institution. They can also use their account to purchase an annuity, effectively converting the account to a "defined-benefit" IRA. However, workers may not borrow against IRA balances, a restriction that does not apply to 401(k) plans.

1.  IRAs are set up under SEPs and SIMPLEs as well, but those accounts require the participation of an employer. Such IRAs are subject to different contribution limits and cannot be mingled with the IRAs discussed here. Otherwise, the management of the accounts and rules concerning distributions are the same as those for traditional IRAs.
2.  EGTRRA extends the "Roth account" concept to 401(k) and 403(b) plans in 2006.
3.  If an individual's earnings are less than $4,000 or if a couple's earnings are less than $8,000, current law limits contributions to the amount of earnings. Excess contributions are subject to an excise tax of 6 percent.