What is an IRA? Individual Retirement Account
An IRA is a savings account with tax advantages, making it an ideal way to start saving for retirement. The two main types of IRAs are your Traditional IRA and the Roth IRAs. Understanding the difference and knowing which type of IRA is right for you is very important.
The two main types of IRA’s
A Traditional IRA is a tax-deferred individual retirement savings account. You pay taxes on your money only when you make withdrawals in retirement. Deferring taxes means all of your dividends, interest payments, and capital gains can compound each year without being hindered by taxes – allowing an IRA to grow much faster than a taxable account.
A Roth IRA is an individual retirement savings account that allows your money to grow tax-free. When depositing to a Roth, you have already paid taxes on the money you put into it, allowing it to grow tax-free, and when you withdraw at retirement, there are no taxes. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn at any time without penalty (subject to some minimal contributions).
Traditional / Rollover IRA
- A Traditional or Rollover Individual Retirement Account (IRA) can be established by most individuals below age 70 1/2 who have earned income and could contribute up to $6,000 (or $7,000 if you are age 50 and above) per year into an IRA. All, some or none of that $6,000 (or $7,000) may be tax-deductible.
- A total $6,000 ($7,000 if you are age 50 or older) deductible contribution per person is available for each working couple if joint income is below $193,000 and below $122,000 for single filers.
- Partial deductibility is available for married couples with combined incomes between $189,000 and $203,000 and single filers with income between $122,000 and $137,000.
- A deductible IRA cannot be established by individuals who participate in the various company, agency, or not for profit retirement plans, including SEP IRAs, SIMPLE IRAs, 401Ks, 403Bs, 457plans, Deferred Compensation Plans, etc., unless their income is below $64,000 for individuals, and below $103,000 for married couples.
- An individual not currently active in a company plan, but their spouse is active, may make a tax-deductible contribution to an IRA if their income is below $193,000.
- Growth within an IRA is not taxable, including dividends, interest, and capital gain. Eventually, monies removed are taxable as ordinary income.
- IRA withdrawals before 59 1/2 may be subject to taxes and even a 10% IRS penalty. Avoidance of the 10% IRS penalty (but not taxes) on withdrawals is available if the owner takes substantially equal periodic payments for at least five years.
- Distributions– Traditional/Rollover IRA withdrawals are required starting after the owner turns 70 1/2. A 50% tax penalty of the amount that should be withdrawn and is later assessed for non-compliance.
- First-time homebuyers can withdraw a lifetime maximum of $10,000 without taxes or penalties.
- Withdrawals from traditional IRAs can be made for a higher educational expense without penalty.
- Various investment choices for funds are available.
- A Roth Individual Retirement Account (IRA) can be established by most individuals regardless of age or income limit.
- A Roth IRA can be established by individuals who participate in the various company, agency, or not-for-profit retirement plans: SEP IRAs, SIMPLE IRAs, 401Ks, 403Bs, 457plans, etc.
- Up to $6,000 ($7,000 if you are age 50 or older) per year per participant can be contributed to a Roth IRA if the earned income is at least equal to the amount contributed.
- No contribution is allowed when modified family annual gross income reaches $203,000 or more per year for married couples and $137,000 or more for single filers.
- Dividends, interest, and capital gain growth within a ROTH IRA are not taxable, and monies eventually removed are tax-free if the account is owned at least five years and the owner is over 59 1/2.
- Unlike Traditional IRAs, there are no minimum distributions and withdrawal requirements after age 70 1/2
- After the account is opened five years, one can withdraw a lifetime maximum of $10,000 (contributions and earnings) without taxes or penalties for a first-time home purchase.
- At any age, for any reason, one can withdraw the amount(s) contributed (not earnings) without tax or penalties.
- Various investment choices for funds available.
Converting to a Roth IRA
- Available as of January 1998. Many traditional IRA investors have the option to convert their Regular IRAs to a Roth IRA.
- Deductible Regular IRAs offer investors a taxable-deductible contribution on funds going into a Regular IRA, tax-deferred growth on all earnings while in a Regular IRA, and taxable income when distributions are taken from a Regular IRA; whereas, ROTH IRAs offer investors a non-deductible contribution going into a ROTH IRA, tax-deferred growth while in a ROTH IRA and tax-free income when distributions are taken from a ROTH IRA under certain conditions.
- Withdrawals from ROTH IRAs are tax-free if accounts are opened at least five (5) years and the owner is over 59 1/2. At any age, after the account is opened for at least five years, one can withdraw a lifetime maximum of $10,000 without taxes or penalties for a first-time home purchase for the account owner or others. At any age, after the account is opened five years for any reason, one can withdraw the amount(s) contributed (not earnings) without tax or penalties from a ROTH IRA.
- Unlike Regular IRAs, there is no requirement to ever withdraw from a ROTH IRA. Hence why these accounts can be held until death and passed on to spouses, children, or other heirs on a tax-free basis.
- No conversion from a Regular IRA to a ROTH IRA is allowed when modified annual gross income reaches $100,000 (married couples filing jointly and single filers) or more per year during the year in which the conversion takes place.
Before rolling over assets from an employer-sponsored retirement plan into an IRA, you must understand your options and make a full comparison of the differences in the guarantees and protections offered by each respective type of individual retirement account. Keep in mind the differences in liquidity/loans, types of investments, fees, and other potential penalties.