Individuals have access to a wide variety of vehicles for investing hard-earned (or not-so-hard earned) money. Some of these, including “individual retirement accounts” (or “IRAs”), provide potential benefits from a federal tax standpoint.
Over the next several weeks, I’ll be issuing a series of posts discussing IRAs in depth – general information, tax treatment, and some limitations and pitfalls. For now, let’s dive into a few basics.
What is an IRA?
Generally speaking, an IRA is a tax-advantaged retirement account owned by an individual, either for his or her own benefit or for the benefit of a third-party (a “beneficiary”). The Internal Revenue Code defines the term “individual retirement account” as follows:
A trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries, but only if the written governing instrument creating the trust meets the following requirements:
- Except in the case of a rollover contribution…no contribution will be accepted unless it is in cash, and contributions will not be accepted for the taxable year on behalf of any individual in excess of the amount in effect for such taxable year under section 219(b)(1)(A).
- The trustee is a bank…or such other person who demonstrates to the satisfaction of the Secretary that the manner in which such other person will administer the trust will be consistent with the requirements of this section.
- No part of the trust funds will be invested in life insurance contracts.
- The interest of an individual in the balance in his account is nonforfeitable.
- The assets of the trust will not be commingled with other property except in a common trust fund or common investment fund.
(6) Under regulations prescribed by the Secretary, rules similar to the rules of section 401(a)(9) and the incidental death benefit requirements of section 401(a) shall apply to the distribution of the entire interest of an individual for whose benefit the trust is maintained. [1]
The general idea is that an individual can place funds into an account that meets the above criteria, and can invest those funds on a tax-advantaged basis. However, as noted above, the individual can only place a certain amount of funds into the IRA each year.
There’s another catch, too. The specific tax advantages, however, depend on the type of IRA used. Fortunately, there are only two: a “traditional” IRA, and a “Roth” IRA.
Traditional vs. Roth IRA
The term “Roth IRA” is defined by the Internal Revenue Code to mean:
An individual retirement plan (as defined in section 7701(a)(37)) which is designated…at the time of establishment of the plan as a Roth IRA. Such designation shall be made in such manner as the Secretary may prescribe. [2]
The term “individual retirement plan” is further defined to include an “individual retirement account” as defined in I.R.C. § 408(a), set forth above. [3]
Any IRA that is not a “Roth” IRA is, by default, a “traditional” IRA.
While both a “traditional” IRA and a “Roth” IRA are tax-advantaged retirement accounts, the actual tax advantages are entirely distinct. A subsequent post will discuss the high-level implications of contributions to, and distributions from, these accounts.
[1] I.R.C. § 408(a).
[2] I.R.C. § 408A(b).
[3] I.R.C. § 7701(a)(37).
