Working people are interested in IRA’s or individual retirement accounts for two main reasons. One reason is obviously to save money for retirement. The other is to find legal ways to reduce the amount of tax paid on money earned or saved during their lifetime. It is a way of holding on to more of your money and allowing it to grow. It is important to understand the basic characteristics of the available IRA’s to choose the one which is best for your specific situation. The language of investment can be very confusing. It is therefore my goal to inform you about the general features of two of the most common IRA’s, the Traditional IRA and the Roth IRA. I will discuss the similarities and major differences of the two and some of the benefits and drawbacks of each of them.
The Traditional IRA is very popular because it is widely available and significantly reduces taxable income. Almost everyone under the age of 70 is eligible for the Traditional IRA regardless of income so long as that income is taxable. There are conditions which can alter your qualification for this IRA such as participation in another retirement plan at work. In the Traditional IRA the average investor is allowed to contribute up to $5,000 dollars per year. If you are over the age of 50, an additional $1,000 per year can be added. Money invested in a Traditional IRA can become tax exempt money. The money that you contribute is never taxed; not at the time of the contribution nor at the time of withdrawal. The amount of money which can be tax exempt is also determined by several conditions that vary from individual to individual. The earnings made in the form of interest are taxed at the time the money is withdrawn. All of the money must be withdrawn at the age of 70.5 at which time the earnings are taxed. No further contributions can be made after this age.
(One of the common questions people ask is, “What if I need the money before retirement age?” This question is particularly important in today’s economy.)
With the Traditional IRA, there are several ways that money can be withdrawn throughout the course of the investment. Money can be withdrawn without penalty after the age of 59.5. Only the earnings will be taxed just as it would if you took it out at age 70.5. Monies taken before the age of 59.5 however are subject to a 10% penalty. An important feature is that funds can be used to purchase a variety of other investments such as stocks, bonds, or certificates of deposit. Money can also be withdrawn to be used for a first time home purchase or higher education.
(Now that you know something about Traditional IRA’s, let me summarize the benefits and weaknesses of this investment tool.)
The Traditional IRA has certain advantages and disadvantages which distinguish it from the Roth IRA. The major benefit of a traditional IRA is that it significantly lowers your taxable income during your working years. For example, if you make $40,000 dollars a year and you contribute $5,000 per year into your traditional IRA, you are only taxed on $35,000 per year. You will never be taxed on that saved money, only on the interest earned when it is withdrawn. There are two major disadvantage of this IRA. One is that tax must eventually be paid on the earnings. Another downside is that it is mandatory to withdraw the funds at age 70.5 and today many people are still working beyond that age.
(Keeping the Traditional IRA in mind, let’s move on to the Roth IRA)
The Roth IRA is an excellent investment tool designed to allow taxpayers, subject to certain income limits, to save money for use in retirement while allowing the savings to grow tax free. The Roth IRA differs from the Traditional in that there are income limits to determine whether or not you qualify. Single filers with an adjusted gross income up to $101,000 qualify for full contributions. People earning between $101,000 and $116,000 can still qualify but only for a partial contribution. If you file jointly, an income up to $159,000 qualifies for full contribution and up to $169,000 for a partial. The amount of money which can be contributed is the same as in the traditional IRA, $5,000 per year and $6,000 per year after the age of 50. Money contributed to a Roth IRA is not considered a tax deduction. The money is taxed at the time of the contribution. In contrast to the traditional IRA, the earnings made on this saved money are never taxed. Dividends grow tax free! The tax benefit is realized when funds are withdrawn. (When you take your money out at retirement, you pay no additional tax).
(Again you may ask, “With a Roth IRA, can I take my money out early?)
With a Roth IRA, there are also ways to withdraw money prior to retirement. A key feature of the Roth IRA is that the funds must be held in the account for at least five years. Money taken out before that is subject to a 10% penalty on any taxable earnings withdrawn. After the money is in the account for five years, it can be withdrawn after age 59.5 or in the event of disability, death or the purchase of a first home, higher education and certain medical expenses. Another notable difference of the Roth IRA when compared to the Traditional is that there is no requirement that money be withdrawn at age 70.5. Contributions can continue as long as the individual or spouse has earned income.
The Roth IRA has certain advantages and disadvantages that distinguish it from the Traditional IRA. A major advantage of a Roth IRA is that significant interest earnings can be accumulated tax free in preparation for retirement. Another advantage is that contributions may continue for as long as the individual is earning taxable income. One limitation of the Roth IRA is that there are significant income qualifications to participate. Another limitation is that contributions are not a tax deduction throughout the individual’s working years.
(Now let’s summarize)
The Traditional and the Roth IRA’s are powerful investment tools which help people save money towards retirement. The Traditional IRA acts as a tax shelter by reducing taxable income through the working years. The Roth IRA acts as a tax shelter by protecting interest earned on retirement savings from taxation. It is important to study the individual qualifications and terms of each IRA before determining which one is best for you.