IRA stands for Individual Retirement Arrangements. It’s a savings account with big tax breaks. Thus, making it an ideal way to save cash for your retirement. An IRA itself is not an investment. It’s just the “basket” in which you keep stocks, bonds, mutual funds and other assets.
In 2011, you can contribute up to $5,000 to an IRA provided you are younger than 50. Married couples can contribute $10,000, as long one spouse has earned income of at least $10,000.
IRA’s are accounts that an individual opens on their and are not provided by a company. Companies provide 401(k)s for their employees. Self-employed individuals and small business owners can open other types of IRA’s. There are several different types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
Based on your income, you might be able to make a tax-deductible contribution to your IRA. The money grows tax-deferred while it is invested. The money is taxed when it is withdrawn. At retirement, you withdraw the money and are taxed. If you withdraw money before you reach 59 1/2 you will owe a 10% penalty and income tax on the withdrawal.
*Note: All traditional IRA’s are eligible to be converted to a Roth.
You can contribute to an IRA if:
- You have access to a retirement plan at work and your income is below $64,000($110,000 for married couples that file joint returns).
- You don’t have an employer-based retirement plan (there are no income limits in this case); or
- One spouse has access to an employer-based retirement plan but your joint income is below $179,000.
If you don’t meet these rules, you can still contribute to an IRA. The difference is that your contribution will not be deductible. You will not get a break on your income tax return for the tax year. However, your investment earnings will still get the same advantage of growing tax-deferred until you must start making withdrawals in retirement.
A Roth IRA is an Individual Retirement Arrangement that is named after its creator, the late Senator William Roth of Delaware. A Roth IRA allows you to save up money that you can use after retirement. Roth IRA presents itself as an alternative to traditional IRA.
The Roth IRA, like all other IRA’s, have certain advantages and disadvantages. If you’re in the middle income bracket, you find the Roth IRA to your favor or advantage. A Roth IRA is considered to be the simplest form of retirement account that a person can have because it provides tax-free growth. As a normal IRA, a Roth IRA is also taxed once, while a normal investment is usually taxed twice. A normal IRA account collects contributions using tax-deductions that are dependent on the amount of income you get, on the other hand Roth IRA is the opposite. When you withdraw your earnings on a traditional IRA, you need to pay taxes. With Roth IRA, withdrawing your earnings is tax-free. That means you do not pay any income tax or capital gains taxes. This works so long as you wait until you are 59 1/2 to withdraw your earnings on your original contributions and you have had the account open for at least five years. You can withdraw your contributions at any age, anytime you want without a penalty or tax. Notice I said contributions and not earnings.
Given the current state of our economy and large deficits, you can expect a tax increase on your income, which is why a Roth IRA is a great investment tool. Additionally, Roths do not have a required minimum distribution (RMD). You can leave your money in there as long as you don’t need it. Conversely, if you have a traditional IRA, you must begin to withdraw your money after you turn 70 1/2. You can also use your Roth as an emergency fund because your contributions are made with after-tax dollars, you are free to withdraw them (contributions only not earnings) at any age without having to pay taxes or penalties.
The contributions limits for a Roth are the same as those of a traditional IRA. In 2011, you can contribute a maximum of $5,000; married couples can contribute $10,000, as long as at least one has earned income of at least $10,000. Also, anyone can invest in a Roth, so long as you meet the income limits.
Singles – Modified Adjusted Gross Income (MAGI) must be under $107,000
Married – MAGI must be below $169,000
*Note: for most the MAGI is the same as the Adjusted Gross Income (AGI) on our federal tax returns.
This already shows us the major difference of what is a Roth IRA as compared to traditional IRA.
At a glance, we can see that it is an advantage to pay the tax right from the outset, during the time that you make your contributions rather than delaying the tax until you get your earnings. This may be a great advantage if the tax rate increases but will prove to be a disadvantage when the tax rate goes down. If that happens, you will lose out on some amount. If you see that this can be a factor in your decision, make sure to weigh the possibility of each situation to determine which type of IRA you will get. There are also other advantages and disadvantages that you would have to consider when choosing an IRA.
One of these considerations would be that that the Roth contributions cannot lower your AGI. If in any case your income is bordering to a tax credit or deduction limit, you cannot adjust your income by making a Roth IRA contribution. Also, the tax benefits in a Roth IRA can only be realized upon claiming your earnings after retirement.
There are a lot of things to consider when choosing an IRA. Always remember to know your options before choosing an IRA. Be sure to know What is a Roth IRA compared to traditional IRA to help you in making your decision.