Individual Retirement Account (IRA’s): What You Need to Know

investment diversification eggs in one basketThere are two basic types of Individual Retirement Account (IRA’s) for you to save for retirement through, Traditional and Roth. I will break out both, explaining the features of each, as well as the advantages and disadvantages of Individual Retirement Accounts as well. Note that this is a basic overview of both. I will not go into every detail of the two plans, I will just highlight the main points, as well as their advantages and disadvantages.

Traditional IRA

A Traditional IRA is a tax-deferred account for saving for retirement. Tax-deferred means that you pay no tax on the money before you invest it in the individual retirement account. The money grows tax-deferred until you withdrawal it in retirement. At this point, you pay tax on the money.

Advantages

  • Tax-deductible contributions: if you meet certain requirements, you can deduct the contribution you make in the year you make it from your income tax.
  • Paying less taxes: It is assumed you will be in a lower income tax bracket in retirement versus when you are working. So by paying the taxes when you are in retirement, you will pay less because you earn less.

Disadvantages

  • At age 70 ½, you are required to take money out of the account each year, regardless if you need it or not. This is known as the Required Minimum Distribution (RMD).
  • Early Withdrawal Penalty: if you withdrawal money before age 59 ½, you will have to pay a 10% penalty to the IRS in addition to he regular income tax.

Roth IRA

A Roth IRA is a tax-free  individual retirement account for saving for retirement. Tax-free means that the money in the account grows tax-free until retirement when you withdrawal it. When you do, you do not pay tax as you already have. The catch is that you pay tax on the money before you invest it in the Roth IRA. (To clear up any confusion, you aren’t getting taxed by investing in a Roth. The money you invest must be earned income (salary). It gets taxed there, not when it gets invested.)

Advantages

  • You pay taxes now. You will not have to worry about taxes being higher when you withdrawal the money.
  • No RMD. With a Roth IRA, you don’t have to worry about turning 70 ½ and being forced to take money out of the account. You can choose to never touch it if you would like and pass it on to an heir after you pass away.
  • No penalty if distributing contributions: At any time, you can take out the amount you deposited into the Roth without facing a penalty. So, if you deposited $1,000 into your Roth and need $500, you can take out the $500 and not have to deal with any IRS penalties.
  • Non-taxable distributions: You can withdrawal money from the Roth IRA, $10,000, for first-time homebuyers, without having to worry about early distribution penalties.

Disadvantages

  • Income limits: You can only contribute to a Roth IRA as long as you meet the income eligibility limits. (But there are exceptions to this.)
  • Taxes: Depending on future tax rates, you could end up being in a higher tax bracket when you make your contributions than you will be in when you withdrawal the money.
  • Legislation: There is no guarantee that the money that grows in your Roth will always be tax-free. Congress could change the law at any time.

For 2012, both Traditional and Roth IRA owners can contribute up to $5,000 in their account ($6,000 if you are 55 or older.)

For many, the Roth IRA is the way to go. This is because you lose the tax deduction of the Traditional IRA contribution if you are covered by an employer’s retirement plan (401k), or earn too much money. For which individual retirement account benefits you the most, be sure to sit down and discuss it with your tax accountant. From there, be sure to find a broker to use to open your account that meets your needs best.

3 thoughts on “Individual Retirement Account (IRA’s): What You Need to Know”

  1. Ahhh…. Roths… if only they would increase the contribution limits! I've been trying to convince my company to go to a Roth 401(k) for a few years, but no dice. I like the predictability (assuming they don't change the rules) over hoping taxes will go down. Given the $$ climate, my guess is net taxes aren't going to be significantly lower any time soon. Risk worth taking for me.

    1. Hahaha!!! I wish they would up the limits too! I only have a regular 401(k) at my work but my girlfriend gets a Roth 401(k). One out of two ain't bad.

  2. A Roth 401(k) is awesome. You missed my IRA though (and hopefully yours one day as well – the SEP IRA. 2011 contribution limit was $49,000! Of course you would need to make nearly $300k to fully fund the SEP IRA as the only employee of your company, but that's surely a goal worth shooting for isn't it?

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