An IRA is a popular investment tool, but many people underestimate just how powerful it can be. Short for Individual Retirement Account, IRAs come in many different types, but the two most popular are so-called “traditional” IRAs and Roth IRAs.
The traditional IRA has been around since the mid-1970s and was created by Congress as a sort of catch-all savings account where people could store various types of investments. Unlike other types of retirement plans, an IRA is opened by the individual and is not sponsored by an employer.
Roth IRAs are a relatively new creation, named after the senator who sponsored the legislation that spawned them. Available since 1997, the main difference between the Roth IRA and the traditional IRA is how your money is taxed. A traditional IRA works much like other types of retirement investments. The money you channel into the IRA is tax deferred, meaning you pay income tax on it when you retire and start making withdrawals – when your income is likely to be much lower. As long as you don’t begin withdrawing money before age 59½, your earnings will sit in the IRA and continue to gain completely tax free. If you take out money before 59½, your withdrawal is subject to both income tax and a 10% penalty. The penalty is waived if you can show your withdrawal qualifies as an exception under IRS rules. Common exceptions include approved higher education expenses and money used toward the purchase of a first home. Under IRS rules, you can contribute up to $5,000 per year to your IRA account. For individuals over 50, this amount increases to $6,000.
In a Roth IRA, the taxes are paid up front. For example, if you earn $40,000 per year and put $2,000 in your Roth IRA account, you still pay income tax on the full $40,000 (with a traditional IRA, you would only pay income tax on $38,000). Just like a traditional IRA, you are allowed to make contributions up to $5,000 each year. Those over 50 are permitted to contribute up to $6,000. Unlike a traditional IRA, you pay no income tax when you begin making withdrawals – no tax on withdrawals and no tax on earnings. To begin making withdrawals completely tax- and penalty-free, you must be at least 59½ years old and the money must have been in the Roth IRA account for a minimum of five years. No matter how much money your investments earn over the years, you pay zero income taxes when you take them out. This tax savings gives the Roth IRA a tremendous advantage over its traditional counterpart.
There are other key differences between the two accounts. Traditional
IRAs require you to begin making withdrawals by age 70½. There is no
such requirement with a Roth IRA. Your money can continue to sit in the
account and continue to earn long after your retire. On the downside,
the Roth IRA has income limits, meaning that individuals who earn over a
certain amount are not eligible to make contributions to a Roth IRA.
For 2012, the Roth IRA is available to single individuals who earn under
$110,000 per year. For married couples, the annual combined income
limit is $173,000.
Because the Roth IRA offers significant tax savings, many people choose to convert traditional IRAs to a Roth IRA account. Prior to 2010, only individuals with an annual income under $100,000 were allowed to convert. This is no longer the case. A change in the law that year did away with the income threshold and now anyone can convert. Navigating the tax regulations can be tricky, however, so it is important to have a good grasp of the rules before making a decision to convert. In order to convert your traditional IRA to a Roth IRA, you must pay taxes on the money being switched over. Because most people tend to have less accumulated investments when they are young, financial advisors recommend converting sooner rather than later to avoid taking a huge tax hit.
An IRA can be a phenomenal investment tool, providing you with a comfortable nest egg for your retirement. It is best to work with an experienced estate planning attorney or financial expert to determine which type of IRA will best further your goals.
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