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IRAs & Roth IRAs

What’s the difference and why should you care?

IRAs offer a great way to invest and save on taxes

IRAs or Individual Retirement Accounts are another popular option for first time investors. Like a 401(k), an IRA offers you an opportunity for your savings to avoid being taxed and as a result, grow faster. However, unlike a 401(k), an IRA is not an investment plan per se, in fact it’s more like a tax free venue for you to buy and sell investments. Like a tax free stocks and bonds trading account. Your annual maximum contribution, however, is currently limited to $5,000 per year for those under age 50, and $6,000 for those over 50.

Once your plan has funds, you can choose where that money is invested. You can invest in a whole host of different mutual funds, individual stocks and bonds, annuities and even certain real estate. All tax free! You can buy and sell as you please and invest in a broad range of investment options that you control. A diverse portfolio is a good way to protect yourself against sudden changes in a stock or funds value. Two popular types of IRAs for employees are traditional IRAs and Roth IRAs.

 

Traditional IRAs are available to almost everyone and once you have made a contribution, you can invest your money in stocks, bonds and funds tax free. With a traditional IRA your money is taxed on the back end. The money you contribute (up to a maximum of $5,000 per year) gets taxed when you start to withdraw it in retirement. WIth a traditional IRA you must begin to withdraw your savings by age 70 and a half.

 

With a Roth IRA the tax situation is the opposite, the money you contribute is taxed on the way in and your retirement savings are withdrawn tax free. There is a catch, however, to a Roth IRA. Not everyone qualifies for this type of IRA.  For this year (2012), your modified adjusted gross income must be no more than $183,000 if you are married and filing jointly. If you are single, head of household or married filing separately, then your income must be $125,000 or less.

 

Who qualifies?

What plan you qualify for really depends on what kind of IRA it is. Practically anyone can open and contribute to a traditional IRA, on condition that you receive a taxable income and you are under age 70 ½.

Contributions made to a Roth IRA are never tax deductible, and in order to make contributions you must meet certain income requirements. Your modified adjusted gross income for 2012 must be $183,000 or less if you are married and filing jointly or $125,000 or less if you are single, head of household or married filing separately.

 

There are several types of IRAs:

  • Traditional IRA – contributions are often tax-deductible (often simplified as “money is deposited before tax” or “contributions are made with pre-tax assets”), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted). Depending upon the nature of the contribution, a traditional IRA may be referred to as a “deductible IRA” or a “non-deductible IRA.” It was introduced with the Tax Reform Act (TRA) of 1986.
  • Roth IRA – contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William V. Roth, Jr., the Roth IRA was introduced as part of the Taxpayer Relief Act of 1997.
  • SEP IRA – a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee’s name, instead of to a pension fund in the company’s name.
  • SIMPLE IRA – a Savings Incentive Match PLan for Employees that requires employer matching contributions to the plan whenever an employee makes a contribution. The plan is similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately.
  • Self-Directed IRA – IRA that permits the account holder to make investments on behalf of the retirement plan.

 

Why you should get one.

An IRA is a great savings option because the money you invest in the plan grows out of reach of the tax man. By that I mean, the income from interest, dividends and capital gains will compound year on year without taxes taking a bite along the way.

In addition to avoiding tax on your investments gains, you can also escape taxes on either the money you put into the plan at the beginning or on the money you withdraw in retirement, depending upon the plan you choose and qualify for. Whichever plan you qualify for, an IRA or Roth IRA provides a great tax benefitting retirement option.

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Early withdrawal.

Many long term investments have penalties for early withdrawal and IRAs are no exception. If you’re 59 ½  or older however, you’re normally all clear. But if you’re lucky enough to be younger than that, you will have your withdrawals get hit with a penalty from traditional IRAs or early withdrawals on earnings from Roth IRAs.

There are exceptions, however, for when you can escape that 10% tax penalty. It can be avoided if you’re withdrawing the money for some specific reasons;

Exceptions include:

  • Paying for your college expenses, your spouse’s, or your children/grandchildren.
  • Paying for medical expenses larger than 7.5% of your annual adjusted gross income.
  • Paying for a first-time home purchase (up to $10,000).
  • Paying for the costs of a sudden disability.

 

If you put money into your IRA but then quickly realize you need that money back, you can often “take back” your last contribution you made to a traditional IRA (without paying any tax), provided you do so before the tax filing deadline of that particular year. You may not deduct this retracted contribution from your taxes.

 

Bottom line.

IRAs and Roth IRAs are a fantastic investment vehicle for anyone starting to invest in their future. Get one.

 

ThirtySomething.

 

 

Image courtesy of sheelamohan / FreeDigitalPhotos.net

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