How does an IRA Work and What Determines How the Yield is Increased?

An IRA is a good way to save for retirement.

An IRA is a good way to save for retirement.

An Individual Retirement Account (IRA) provides a tax-advantaged way to save. It can be particularly valuable if you aren't covered by a retirement plan at work, such as a 401(k). To maximize the benefits of an IRA, you'll have to follow Internal Revenue Service rules regarding contributions and distributions. If you manage your IRA properly, you can help increase the yield on your account.

Contributions

The IRS allows anyone to contribute up to $5,000 per year to an IRA account as of 2012. If you are age 50 or older, you are permitted to contribute an additional $1,000, for a total of $6,000. You must have taxable compensation, such as your salary, of at least as much as your contribution. For example, if you only earn $4,000 in a given year, your IRA contribution will max out at $4,000. You can contribute an additional $5,000 for your spouse, even if she is not working, as long as the two of you have a combined taxable income of at least that amount.

Taxation

To encourage you to contribute to your IRA, the IRS lets you take a tax deduction equal to the amount of your contribution. If you and your spouse aren't covered by any retirement plans at work, you can always deduct the full amount of your contribution. However, if at least one of you is covered, your deduction phases out based on your adjusted gross income. If you are married filing jointly and your spouse is the one covered by an employer plan, your deduction phases out if you make between $169,000 and $179,000 of AGI. If you are the one covered by the plan, your deduction phases out between $90,000 and $110,000.

Required Distributions

You can't leave money in your IRA forever. Eventually, the IRS forces you to take withdrawals known as required minimum distributions. After you turn 70 1/2, you'll have to start taking distributions at least annually, with the amount based on a combination of your account value and your life expectancy. The IRS reserves one of its stiffest penalties for the failure to take an RMD -- 50 percent of the amount you should have withdrawn.

Increasing Yield

An IRA is an account, not an investment. To increase the yield on your IRA, you'll have to invest smartly. You can put almost any type of investment in an IRA, from stocks and bonds to mutual funds, exchange-traded funds (ETFs) and certificates of deposit (CDs). One of the few things you can't buy in an IRA is life insurance. If you are searching for income, you can buy bonds in your IRA; if you prefer capital appreciation, you may lean more towards buying stocks. However, you can't take money out of your IRA before age 59 1/2 without paying taxes and a 10-percent early-withdrawal penalty. The investments you choose should be the ones that increase your account value the most while remaining within a level of risk that you can tolerate.

 

Photo Credits

  • Jupiterimages/liquidlibrary/Getty Images