What is an IRA?
IRAs are investment retirement accounts. They are meant for retirement planning. Every person with an IRA account basically contributes a certain amount every paycheck to his/her retirement account and slowly works towards building up a corpus. This corpus is the retirement fund from which amounts of money can be regularly withdrawn to pay for expenses after retirement. Since retirement stops the flow of work income or salary, another stream of income is needed to sustain financially, and IRAs provide that source.
When you invest in an IRA account, your money actually gets invested into a variety of asset classes such as stocks, bonds, and mutual funds. You may say to yourself how an IRA account is different from simply investing money in stocks, bonds, and mutual funds. The key difference between investing directly and investing through an IRA account is the tax treatment.
So what are some of the benefits of investing in an IRA?
Since IRA accounts are designed for retirement, they have certain tax benefits. Depending on the type of IRA account you opt for, you can get tax deductions on your contributions or you can get tax free withdrawals during your retirement. There are some limits on how much you can contribute to an IRA account every year. Another benefit of an IRA account is the fact that certain companies/employers contribute or match your contributions if you invest a certain portion of your paycheck into an IRA account.
What are the different types of IRA accounts?
There are many types of IRA accounts: a traditional IRA, a Roth IRA, a SEP IRA, Rollover IRA, Simple IRA, etc. However, the two most commonly used IRA account types are the traditional IRA and the Roth IRA. Both these types of IRA account mainly differ across 4 key features. Those features are taxes, early withdrawal rules, contribution limits, and minimum required distributions.
There is also a limit to how often a debt collector should contact the defaulter. If the debt collector contacts the borrower too frequently, it will be counted as harassment.
- Taxes: This is the number one point of differentiation. Tax efficiency is the whole reason why IRAs have good utility. There are two types of income trends that most people would experience in their life. First, you may be an average to low-income earner who expects the income to go up post-retirement because of IRA withdrawals.
The traditional IRA allows tax deductions on contributions which you make during your working life. Hence, you can claim deductions on your contributions every year when you file your annual return. However, when you withdraw the funds in retirement, you pay taxes on those withdrawals because you have already enjoyed the deductions earlier on in your life. A traditional IRA is clearly more beneficial to a high income earner, who can take advantage of deductions during the high earning period (when tax rate may be in the higher slab) and then pay smaller amounts of taxes on the lower withdrawal income during retirement years (as the slab may be in the lower tax rate).
A Roth IRA, on the other hand, does not have any provisions for tax deductions on contributions made to the IRA. Hence, you pay your taxes all through your working life. However, when you retire and withdraw money from your accumulated Roth IRA corpus, the withdrawals are tax-free. So, a Roth IRA would be beneficial to someone who had a low/average income level and expects that income to jump because of the withdrawal stream of income. That increased income may cause the person to end up in a higher tax bracket. Either way, the withdrawal and the growth of the investment corpus will be tax-free.
- Early withdrawal: Withdrawal of money from an IRA account prematurely is not recommended. The tax rules and penalty rules are framed in a way to discourage you from withdrawing early. After all, IRA is meant for your retirement. But, there are times or situations in certain people’s lives that compel them to make that early withdrawal. If they do so before turning 59.5 years old, then both the traditional and Roth IRA charge a 10% withdrawal penalty.
In addition to the penalty, the withdrawals from a traditional IRA are considered as income and hence taxed at whatever your current tax rate is at the time of withdrawal. There are exceptions to these penalties if you are withdrawing money for a specific purpose such as buying your first home (up to $10,000 withdrawal), higher education expenses of certain types, and certain medical expenses.
In case of the Roth IRA, the rules are a bit different. In a Roth IRA, the time from the first contribution to the withdrawal is important. 5 years is an important metric. If you are younger than 59.5 years and have had a Roth IRA for less than 5 years, then taxes and penalty are coming your way. The penalty can get waived if you are in a particular situation, like buying your first home, paying for higher educational expenses, or medical expenses, etc.
If you are younger than 59.5 years and have had a Roth IRA for over 5 years, you still get hit with the penalty and tax, but there are some situations where both of those can be waived. The situations are similar to what was pointed out above in case of traditional IRA and Roth IRA. Check with an accountant for accurate info.
If you are older than 59.5 years but have had a Roth IRA account for less than 5 years, then you will have to pay tax, but there will be no penalty. And finally, if you are over 59.5 years and have had a Roth IRA for over 5 years, then no penalty and no tax.
- Contribution Limits: The traditional IRA and Roth IRA have a limit as to how much you can contribute to those accounts every year. As a general rule, the limit for both types of accounts is $5,500 if you are under 50 years and $6,500 if you are 50 years or older. It is possible to contribute your money to both types of accounts in a single year as long as the aggregate contribution does not exceed the above-mentioned limits.
However, there are some scenarios in which the interpretation of these limits changes. For example, if you are in the very high income category, then you are in some cases not eligible to contribute to a Roth IRA account. For example, if your individual income is over $135,000 or if your joint family income is $199,000, then you are not eligible to make Roth IRA contributions. A traditional IRA has no such income-based limit. You can make contributions irrespective of what your income limits are.
From a tax deduction point of view, there are limits linked to your income for how much amount you can claim as tax deduction when contributing to a traditional IRA account. For example, if your joint family income is over $121,000, then you cannot claim tax deduction on those $121,000. You can only claim up to a certain limit. If you are an individual, $199,000 is the income limit. Similarly, there are limits on other marital status and personal scenarios. But basically, the point is that in a traditional IRA, you get full deduction up to a certain income level, partial deduction beyond that level up to another point, and then absolutely no deduction beyond a certain limit as pointed out above. Remember, the deduction that we are talking about is on the $5,500 or $6,500 that you contribute every year. The deduction on that amount is decided by your income level.
- Minimum Required Distributions: In a traditional IRA account, contributions can be claimed for deductions. Hence, the IRS has given you the benefit for many years. So, once you turn 70.5, the IRS expects to get some of the foregone tax back. Hence, there will be a minimum withdrawal requirement that you will have to follow so that IRS gets their tax. This works well if you are going to be dependent on IRA income for your lifestyle. However, if you are financially well-off and have other sources of income, the forceful withdrawal will disrupt your investment growth. You will have to withdraw money which you don’t really need to. And if by some chance you are still working after 70.5 years and want to make contributions, then you will not be allowed to do so.
In case of the Roth IRA, the rules are very liberal. There are no minimum required distributions and you can let the money sit in the Roth IRA for as long as you like. If you are someone who wants to pass on your Roth IRA corpus to your heirs, then Roth IRA is a more favorable option. What’s more, you can continue to contribute to a Roth IRA account even after the age of 70.5 years.
By understanding these vital differences, you will be able to make an informed decision on which IRA account you should invest your money in. Based on your needs and preferences, you will be able to figure out the most optimum allocation between a traditional IRA account and a Roth IRA account.