IRA stands for Individual Retirement Account.
Quite simply, these are accounts that are set up by individuals rather than by employers.
Opening an IRA is very easy and requires only taxable income and a little paperwork. Most banks and investment firms allow users to open these accounts in a matter of minutes.
Once an account is open, it can be funded with any type of investment, such as stock, mutual funds, bonds, and index funds.
There are, however, two types of IRA accounts – the traditional IRA and the Roth IRA.
Choosing which of these is best sometimes proves challenging.
The money that’s deposited into a traditional IRA can be deducted from taxable income each year, thus reducing immediate tax liability.
That money will then sit in an IRA, earning interest, without ever being taxed.
Taxes are collected, however, upon withdrawal. Because of this, traditional IRAs offer tax deferred growth.
In addition to this unique tax layout, traditional IRAs have a contribution limit of $5,500 per year.
While this is much less than the limitations of a 401(k), for those without access to a 401(k), traditional IRAs are, at the very least, better than nothing.
However, there’s no limit on the number of IRA accounts a person may have open. Several traditional IRA accounts would allow for more savings, but if any one account sees more than a $5,500 deposit, a 6% penalty goes into effect based on the amount exceeded.
Users are able to deduct their yearly contributions, up to $5,500, of each IRA from taxable income each year.
Nevertheless, there are two qualifiers for these deductions, as well.
- If an employer doesn’t offer a retirement plan, the full $5,500 contribution to a traditional IRA can be deducted. There is, of course, a minor exception to this rule – if an individual’s employer doesn’t offer a retirement plan, but their spouse’s employer does, the full contribution can be made only if the combined gross income is $166,000 or less and taxes are filed jointly.
- If your employer does offer a retirement plan, the traditional IRA contribution might not be fully deductible. If a person opts for an IRA rather than invest in a 401(k), this will incur limitations upon tax deductions. This rule is in place to encourage people to use their employer’s retirement plan. If a person invests in both options, tax limitations may still apply but to a lesser degree.
The full $5,500 investment is tax deductible for someone who is:
- Single with an adjusted gross income of $56,000 or less.
- Married, having filed a joint tax return, with a gross adjusted income of $90,000 or less.
- Married, having filed separately, with a personal adjusted gross income of less than $10,000.
Clearly, figuring out how much to deduct can take some work. The IRS has provided this worksheet for guidance.
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Once an IRA has been established, a person can begin withdrawing from the account without penalty at the age of 59 and a half. Early withdrawal will result in the payment of delayed income taxes plus an additional 10% penalty.
The IRS makes some exceptions if the money is being used to cover educational or health insurance expenses, or if the funds are going towards the purchase of a first home.
A person must begin making minimum distributions from a traditional IRA account by the time that person is 70 and a half years of age. There is, of course, a penalty if these regulations aren’t followed.
Created in 1997 by Delaware Senator William Roth, the Roth IRA differs, most significantly, from the traditional IRA in that the account holder doesn’t receive an upfront tax break upon contributing to the account.
Unlike traditional IRAs, Roth IRAs take deposits after tax dollars. However, there are no income taxes applied when the money is withdrawn, so long as the account holder is over the age of 59 and a half.
The contribution limit is the same, but it also depends on a person’s income. The full $5,000 can be deposited if a person is single and their adjusted gross income isn’t more than $107,000, or that person is married and files jointly with an adjusted gross income not exceeding $169,000.
If a person makes more than those limitations but less than $122,000 (singles) or $179,000 (married couples), a Roth IRA may still be open, but a person can’t contribute the full $5,000 per year. Outside of those second parameters, however, account holders may not make deposits into a Roth IRA.
Like a traditional IRA, users can avoid paying taxes or penalties on withdrawals if the money is going towards the purchase of a first home or to cover a disability.
However, there are no required withdrawals at any age. The money is permitted to stay in a Roth IRA after the age of 70 without any penalties.
Which to Choose
Traditional IRAs and Roth IRAs may seem simultaneously similar and dramatically different, but the best choice really depends on a person’s earnings and investing – both present and future.
In order to make the best choice of the two types of retirement accounts, it’s crucial to take a financial status inventory. An account holder will need to understand their current status and make some predictions on where they might be down the road.