IRAs are a common and valuable tool for retirement planning. An IRA allows you to plan, save and invest in your retirement, with added tax benefits. There are various types of IRA accounts available, including individual accounts, as well as, employer-sponsored accounts. If you are trying to choose which type to create for yourself, know that a Roth IRA and a traditional IRA are different in some ways.
What is an IRA, basically?
An IRA, which stands for Individual Retirement Account, is a tax-deferred savings plan, created within IRS guidelines. Both traditional IRAs and Roth IRAs are created by individuals, not provided or sponsored by employers. They each have different contribution limitations, tax implications and rules regarding withdrawal of funds.
Differences in eligibility requirements
There are no income limits for a traditional IRA. However, how much you can contribute to a Roth IRA depends on your tax filing status and your modified adjusted gross income (MAGI). According to the IRS, your contributions to a Roth IRA can be “phased out” (reduced) based on the IRA phase-out ranges. In 2015, the Roth IRA phase-out ranges are:
Filing status: Single
Income range: $116,000–$131,000
Filing status: Married, filing jointly
Income range: $183,000–$193,000
Earned income is considered any money you earn for work you performed on the job. If you own a small business, your earned income is considered the profit distributions from the business. Income generally includes wages, salaries, tips, bonuses, commissions, and self-employment income. Income such as military differential pay and taxable alimony, is also included. On the other hand, earned income does not include interest and dividends from investments, income from rental property, and pension payments.
Differences in tax benefits
There are very generous tax breaks associated with both the traditional and Roth IRA. The main difference is when and how those tax breaks are applied. For example, contributions to traditional IRAs are tax deductible on both state and federal tax income returns, during the year your contributions are made. Withdrawals from traditional IRAs, upon retirement, are taxed at the regular income tax rate, at that time. Roth IRAs, on the other hand, do not provide any tax benefits relating to contributions. However, the earnings and withdrawals from Roth IRAs are typically tax free. So, you avoid taxes when you contribute to the traditional IRA, but you avoid taxes with the Roth IRA when you withdraw money at retirement.
Differences in withdrawal rules
There are certain rules and limitations on when you can withdraw money from your IRA, and what the penalty will be, if any. One difference is that Roth IRAs do not have mandatory withdrawal requirements. Whereas, you are required to take distributions from a traditional IRA at age 70 ½, if you have not already. So, if you don’t need the money in a Roth IRA, you can leave it in the account and allow it grow tax free until your death. Both types of IRAs allow you to begin receiving distributions, penalty free, at age 59 ½. The only limitation with a Roth IRA is that the first distribution must be five years after the first contribution.
If you have questions regarding IRAs, or any other retirement planning needs, please contact the Schomer Law Group either online or by calling us at (301) 337-7696.