An IRA is an important retirement tool. It allows individuals to plan, save and invest in their future retirement. The type of individual retirement account you choose is significant. So, being familiar with the differences between traditional and Roth IRA can help you make the best decision for your retirement.
What is an IRA?
An Individual Retirement Account (IRA) is a tax-deferred savings plan, established under the IRS guidelines. There are four types of IRAs, two that are established by the individual and two that are provided through your employer. The two types of employer IRAs are 401K and 403B while the two types of individual IRAs are Traditional and Roth IRAs. They have differences in their limitations, tax implications and withdrawal rules. In this article, we will be discussing the two types of IRAs established by the individual.
Different Limitations on Income
One of the eligibility requirements for IRAs is income. With a Traditional IRA, anyone who has earned income and is younger the 70 1/2, is allowed to make contributions to the IRA. However, a Roth IRA has different income-eligibility restrictions. A single taxpayer must have an annual income less than $114,000 in 2014. If you are married and filing jointly, your annual income must be $181,000 or less.
What is “earned income?”
Earned income is any money paid to you for work you performed on the job. If you own a small business, then it is considered your profit distributions from the business. This income includes wages, salaries, tips, bonuses, commissions and self-employment income. Taxable alimony and military differential pay is also included. Earned income does not include things like interest and dividends from investments, income from rental property or pension payments.
Differences in Tax Incentives
Both types of individual IRAs provide very generous tax breaks. Traditional IRA contributions are tax deductible on both state and federal tax returns, during the year you make the contribution. On the other hand, withdrawals in retirement are taxed at the ordinary income tax rates.
The difference is, Roth IRAs do not provide a tax break for contributions, while the earnings and withdrawals are typically tax-free. Put more simply, you avoid taxes when you put money in a traditional IRA. With Roth IRAs, you avoid taxes when you take money out in retirement.
Withdrawal rules are different
When you can withdraw from your IRA, and what the penalty may be, differs between traditional and Roth IRAs. First, traditional IRAs require distributions to be taken at age 70 ½. Roth IRAs do not have mandatory withdrawal requirements. This means, with a Roth IRA, if you do not need the money, the IRA can continue to grow, tax-free, throughout your lifetime. This makes a Roth IRA a perfect wealth-transfer tool, because beneficiaries will not owe income tax on withdrawals and the distributions can be spaced out over many years.
Owners of both types of IRAs can begin taking penalty-free “qualified” distributions, beginning at age 59 1/2. But, the first distribution from a Roth IRA must be five years after the first contribution.
If you have questions regarding IRAs, or any other retirement planning concerns, please contact Sexton, Bailey Attorneys, PA online or by calling us at (479) 443-0062.