Individual Retirement Accounts (IRAs) are common financial instruments used in retirement planning. They allow you to prepare for your future retirement. There are different kinds of retirement accounts, with different requirements and different advantages. That is why it is useful to have at least a basic understanding of the differences between two of the most common types of IRAs. That way, you can be better prepared to decide: traditional or Roth IRA.
What is an Individual Retirement Account or IRA?
An Individual Retirement Account (IRA) is simply a tax-deferred savings plan. An IRA must be created under the specific rules required by the Internal Revenue Service. Some IRAs are purchased by individuals and some are sponsored by employers. Both Traditional and Roth IRAs are set up by the individual. Each type of IRA has specific income limitations, tax implications and rules governing the withdrawal of funds.
Income Limitations of Traditional and Roth IRAs
IRAs have detailed eligibility requirements, including the maximum amount of income an individual can earn in order to remain eligible for each type of retirement account. A Roth IRA has more restrictions when it comes to income limitations. A Traditional IRA can be established by anyone who has earned income and is younger than 70 ½ years old. However, to be eligible for a Roth IRA, an individual cannot have more than $116,000 in earned income, in 2015.
Earned income is defined as the money you are paid to work on the job, including wages, salaries, tips, bonuses, commissions and self-employment income. Earned income does not include interest and dividends from investments, income from rental property, and pension payments.
Tax incentives for Roth and Traditional IRAs
Although both types of IRAs offer substantial tax breaks, when the tax can be avoided is not the same. Both the earnings and withdrawals are typically tax free for Roth IRAs, and there are no tax breaks related to contributions. On the other hand, traditional IRA contributions are tax deductible during the year you make the contribution. This is true on both state and federal income tax returns. However, any withdrawals that are made during retirement are taxed at the ordinary income tax rate. In other words, a Traditional IRA avoids taxes when the money is put into the account, while the Roth IRA avoids taxes when the money is withdrawn at retirement.
Rules regarding withdrawal of funds
There are rules regarding when funds can be withdrawn and what the penalty will be, if any. These rules are different for Roth IRAs and Traditional IRAs. Roth IRAs do not have any mandatory withdrawal requirements. But, Traditional IRAs require you to receive distributions of funds no later than age 70 ½.
While you are allowed to begin taking penalty-free distributions at age 59 ½, with either type of IRA, a Roth IRA requires the first distribution to occur at least five years after the first contribution.
If you have questions regarding Individual Retirement Accounts, or any other retirement planning needs, please contact Sexton, Bailey Attorneys, PA online or by calling us at (479) 443-0062.