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One of the main benefits of an IRA is one that we mentioned in a previous paragraph. It allows you to supplement your current savings in an employer-sponsored retirement plan. But there are two other important benefits. First, in most cases an IRA permits you to access a wider range of investments then your employer-sponsored plan. And second, it allows you to take advantage of tax-deferred or tax-free growth.
Important IRA terms to know
If you do have an IRA or are thinking of starting one, there are some terms that are important for you to know and here are seven of them.
Adjusted gross income or AGI
Your AGI is used to determine your federal income tax. It includes all the taxable income that you received the past year such as wages, interest, capital gains and dividends minus things like moving expenses, business expenses, capital losses, alimony, and contributions to qualified IRA.
You can put money into an IRA as long as you earn money. And if you are age 55-plus, you can make some additional contributions. However, regardless of your age your contributions can't exceed your earned income.
Non-deductible or deductible
If you are in a plan such as a 401(k), it's possible that you could still deduct your contributions to an IRA. This will depend on your filing status and income. In comparison, the contributions you make to a Roth IRA are not tax deductible.
MAGI or Modified adjusted gross income
Some people use their MAGI to determine how much they can contribute to an IRA. However, for most people their MAGI will be the line on the tax form labeled "adjusted gross income," or AGI. However, some taxpayers will choose to modify their AGI by adding back some of their tax breaks or income. These add backs can be anything from foreign income that you didn't have to include in your adjusted gross income to income from series EE bonds and from qualified educational costs to contributions to a traditional IRA.
Required minimum distribution
In the event you have a traditional IRA, the law requires you to begin withdrawing money from the account by or before April first of the year after you become 70 1/2. The amount you will be required to withdraw will be based on your life expectancy and your age. There are simplified tables on the IRS website you could use to calculate what your required minimum distribution will be. Be aware that if you don't make those withdrawals on time, you will be hit with an excise tax. If you have a Roth IRA it will not be subject to a required minimum distribution until you die.
This is the word used when you reinvest money from one tax-deferred retirement plan to another within 60 days. As a general rule, 20% of the funds you roll over will be withhold for tax purposes if you take possession of the funds. The way to avoid this is by doing a direct rollover, which is a trustee-to-trustee transfer instead of from one retirement account to another.
Tax- and penalty-free withdrawals
The law says that you can withdraw money from your IRA without paying any taxes or penalties so long as you pay it all back within 60 days. However, be aware that you can only do this once a year. While these are not supposed to be used as 60-day loans, some account holders use this rule to loan money to themselves. Many financial experts warn against this. They say the situation comes with many dangers including not having the money, missing the 60-day deadline and incurring taxes. One financial advisor says that using the money from an IRA as a fast loan should be a last resort.
Some years ago this was renamed the Coverdell Education Savings account. However, you might still hear the term Education IRA. Since this account is not used to finance retirement it is not strictly an IRA. But when it was created its rules made people think of an IRA, hence the nickname. You can make contributions to a Coverdell Education Savings account of up to $2000 per child to help with educational costs. While you can't deduct the contributions from your income taxes, the money you earn will be tax deferred and in the case of certain schools the money you withdraw will be tax-free.