IRAs are one of the most frequently misunderstood investments that a person has in their portfolio. While it remains unclear as to why the IRA is a source of such great confusion, we've come up with this list of frequently asked questions about IRAs that we will answer in an attempt to provide some much-needed clarity.
What Is an IRA?
An IRA is a financial investment that allows you, the worker, to save money for your retirement. The idea is with an IRA is that you will save enough money over the course of your working life to take care of you from your retirement until your death, without compromising your standard of living.
There are two different types of IRAs:
- Traditional IRA. Originally created by the United States government, the traditional IRA is tax-deferred until the money is withdrawn. In addition, the contributions made to the traditional IRA are tax deductible.
- Roth IRA. While this is a newer IRA than the Traditional IRA, the main difference is that the contributions to the Roth IRA are not tax deductible. However, the payout is tax free.
What Are the Main Differences Between the Two IRAs?
The traditional and the Roth IRA are extremely different investment opportunities.
The Traditional IRA:
- Has contributions that are tax deductible
- Will cause you to incur taxes on any withdrawals you take
- Has a withdrawal penalty (for the most part) if you take any money out of the account prior to your 59th birthday
- Is not applicable for people who are 70 and older
- Requires distributions beginning on the owner's 70th birthday
On the other hand, the Roth IRA:
- Does not have tax-deductible contributions
- Allows for tax-free withdrawals
- Has a withdrawal penalty (with some restrictions, including the Roth IRA five-year age-out plan) of 10% on growth if you take any money out of the account prior to your 59th birthday. There are no penalties for taking out principal.
- Has no age requirement to get started
- Has no required age-out distributions
Are There Limits to the IRA?
There are a few contribution limits to both the Traditional and the Roth IRA that owners need to consider.
Overall, you may not contribute more than $5,500 in a given year if you're under 50 and $6,500 per year if you're 50 or older.
There are also income limits that determine whether you can contribute to a Roth IRA. For the 2016 tax year, if you're single you can make up to $132,000, if you're married filing jointly up to $194,000 and if you're married filing separately $10,000, before you are no longer allowed to contribute to a Roth IRA.
By contrast, there are no income limits for a Traditional IRA. It is possible to continue contributing to a Roth IRA even if you make too much to contribute directly, a process called a "backdoor Roth." This involves contributing to a Traditional IRA and then converting it into a Roth. However, an IRA conversion does require you to convert all of your traditional IRA accounts to Roth, so this may not be the best option for everyone.
How Do I Withdraw Money From My IRA?
With a traditional IRA, you can withdraw money at any time. However, you must be aware of the penalties that are associated with any withdrawal. In addition, you need to be prepared to pay for your penalties at the end of the year, when you file your taxes. You are required to withdraw from your traditional IRA beginning on your 70th birthday.
With your Roth IRA, however, you may withdraw your principal contributions at any time with no tax penalties, though growth will be penalized and taxed.
Before you withdraw any money from your IRA, make sure you consult with your accountant or your preferred tax professional. You may also, at any time, convert your traditional IRA to a Roth IRA if it makes financial sense. This is something that you will also want to speak to your accountant or preferred tax professional about, as well.
Can I Contribute Annually to My IRA?
Yes, absolutely! However, there are some limitations:
- If you are under the age of 50, you may contribute $5,500 or 100 percent of your income, whichever is less.
- If you are over the age of 50, you may contribute $6,500 or 100 percent of your income, whichever is less.
- According to IRS Publication 590-A, "if you or your spouse are covered by a company plan and are an active participant, you must look at your total Modified Adjusted Gross Income for the year to determine if you are eligible for a full or partial deduction."
- You may qualify for a full, or a partial, tax deferral. For more information, please consult with your accountant or preferred tax professional.
Overall, What Are the Benefits of Having an IRA?
For a Roth IRA, there are a number of benefits:
- Your contributions are taxed but growth is tax-free
- You can withdraw without tax penalties
- Once the account has been open for five years, you can take out your money for your use whenever you wish
- You don't have to take required minimum distributions. You can take out what you want, when you want.
- This IRA is perfect for people who are in a higher income/tax bracket.
For a Traditional IRA, there are a number of benefits:
- Your growth is tax-deferred
- You can get this IRA no matter your income/tax bracket.
- You have until April 15th of the following year to make your contributions for the previous year and still get the tax benefits.
- You have the option of making non-deductible contributions, which will then be tax-free at the end of the year. (Make sure you keep track of the contributions you make, and consult with your tax professional with any questions.)