It's never too late or too early to think about your retirement. One of the most common and effective retirement savings options is an individual retirement account, more commonly referred to as an IRA. This article will look at the differences between a traditional IRA and another type of savings account called a Roth IRA.
There are numerous financial products that will, if used correctly, both save and make you money for your retirement. When planning, remember the old adage, "It's not what you make, but what you keep." That's wise advice, and it sounds like something your father might say. Or maybe it was Ben Franklin. No, he said, "A penny saved is a penny earned."
The point is that when you make money, you are producing income. The United States Internal Revenue Service (IRS) taxes your annual income. That is why you need to file a return every April. At retirement, you don't want to sell your 5,000 shares of the Smartphone company stock that you've owned since you were five and since the company was the first on the market. Here’s why: Your stock will have undoubtedly increased significantly. For example, the difference between what you (or your wise relative) paid, say $1.00 per share, and the price 60 years later when you quit working, $21.00 per share, is all considered income. However, that $100,000 that you made by selling the stock needs to be reported to the IRS. That event will have a major impact on your tax situation that year. Under today's tax guidelines, you would be handing over at least $10,000 of that cash to the IRS — and depending on your income it could be as high as $39,600. Of course, no one can accurately predict the tax rates for the year when you retire, but rest assured Uncle Sam will want to see some of that money to keep his government running.
The better option in planning for retirement is to reduce your tax impact, or to pay less in taxes and keep more for your family. Fortunately, there are two types of IRAs that allow you to do this legally and save more for your golden years.
A traditional IRA helps you save for retirement and gives you certain tax advantages. Generally, the savings in your traditional IRA (including earnings and gains) are not taxed until distributed at your retirement. There are several types of traditional IRAs, but we will look at the two most common.
First, an individual retirement account is a trust or custodial account set up for the exclusive benefit of either you or your beneficiaries. The account has certain requirements as to the trustee and the types of contributions that can be made into the IRA. Second, an individual retirement annuity is an annuity contract or an endowment contract from a life insurance company. This IRA also has strict rules on transferring money to another person and the amount that can be contributed.
As a general rule, the IRS says that you can start and make contributions to a traditional IRA if you meet the two following conditions: (i) you (or, if filing jointly, with your spouse) received taxable compensation during the year; and (ii) you were not 70½ years old by the end of the year.
Another great thing about a traditional IRA is that you can have one regardless of whether you are covered by another retirement plan. In other words, if you have a 401(k) at work or other annuities or tax-deferred investments, an IRA is an added option. Don't choose one — invest in them all! The fine print: you may not be able to deduct all of your contributions if either you or your spouse is covered by an employer retirement plan. Of course, this depends on your circumstances. Luckily, the IRS has free guidance in the form of its Publication 590. This booklet (or website) has valuable information on IRAs and your taxes.
The same combined contribution limit applies to all of your Roth and traditional IRAs. Your Roth IRA contribution might also be limited based on your filing status and income. If you are a little older and just starting your IRA, I have good news for you: you are allowed a larger contribution so you can catch up.
For a traditional IRA, you must start taking distributions by April 1st of the year following the year when you reach the age of 70½. Thus, the money you put into your IRA wasn't part of your taxable income for all those years, saving you considerable sums while you filed your annual returns.
Note that there is a 10% federal penalty tax on withdrawals before the age of 59½ unless your situation meets one of a few exceptions.
A Roth IRA, as you would imagine, is simply an IRA that, except as discussed below, is subject to the rules that apply to a traditional IRA. This special savings plan was created as part of the Taxpayer Relief Act of 1997 and takes its name from its main sponsor, Senator William Roth of Delaware.
Think of this as an IRA with VIP perks: a traditional IRA's taxes are deferred until retirement, but a Roth IRA is tax-free. Other major differences include the following:
- You can make contributions to your Roth IRA after you reach the age of 70 ½.
- You keep some money in your Roth IRA as long as you live.
- The maximum amount you can contribute depends on your income.
- There are no required minimum distributions (as there are with a traditional IRA).
Your modified adjusted gross income must be within the IRS' limits, but if you are reading this or haven't heard of a Roth, chances are that you qualify.
The distributions from your Roth IRA contributions are tax-free, and the distributions of your earnings are federally tax-free if you've had your Roth IRA for more than five years and you're over 59½ years old (or you're less than 59½ and you've had your Roth IRA for at least five years, and the distribution is due to your death or disability or for a first-time home purchase, with a $10,000 lifetime maximum).
Like the traditional IRA, there is a 10% federal penalty tax on a withdrawal of your earnings before you reach the age of 59½ unless one of the above exceptions applies. You usually need to contribute before April 15th for the past year (April 18th in 2016), so when you file your annual income tax return, make sure you've made your IRA contributions!
Remember that you should also look at your state taxes and see how (or if) they address IRAs.
IRAs are a great way to save money for your retirement. Put the money in and let it grow until you really need it down the road. Go to www.irs.gov/Retirement-Plans to learn more.