- An individual retirement account is commonly referred to as an IRA. It is a personal retirement savings plan that gives the owner tax benefits designed to increase the amount accumulated for retirement. There are two types of IRA. They are the traditional IRA and the Roth IRA. They differ in the way they give you tax breaks and how you can contribute to them.
- Anyone with earned income can open and contribute to a traditional IRA. Up to certain income limits the contributions are tax deductible meaning the money invested is tax free. If you exceed the income limits your contributions are not tax deductible. Only taxpayers who meet the income requirements can open and contribute to a Roth IRA. Contributions to a Roth IRA are not tax deductible but they are more flexible than a traditional IRA. You can make contributions to a Roth IRA when you are older than seventy and one-half years. A traditional IRA forbids it. There are limits on the amount you can contribute to a traditional IRA and a Roth IRA in a tax year. Check with the Internal Revenue Service for current limits and rules concerning the IRAs.
- A traditional IRA allows you to deduct your annual contribution from you taxes in the year you contribute, as long as you meet income requirements. Your traditional IRA then grows tax deferred. You do not pay taxes on the money in your traditional IRA until you take distributions in retirement. Assuming you are in a lower tax bracket in retirement than while you were working, you will end up paying less in taxes. With a Roth IRA your contributions are taxed but the account grows tax free and distributions are tax free upon retirement.
- A traditional IRA requires you to start taking distributions at seventy and one-half years. You are not required to take distributions at any age with a Roth IRA. If you are older than fifty-nine and one half years and your Roth IRA has been open at least five years, you can take Roth IRA distributions tax free. Otherwise you will be charged a 10 percent early withdrawal penalty. The IRS makes exceptions for higher education expenses, a first time home purchase, certain medical expenses, an IRS tax bill or the death of the account owner.
- The Roth IRA has been immensely popular since its introduction. Millions of investors have chosen to "rollover" their traditional IRAs to Roth IRAs to take advantage of the long term tax advantages. When this is done the traditional IRA is cashed out and taxes levied. Once the taxes are paid the money can be deposited into a Roth IRA. It then grows there until distributions are taken. If they are qualified distributions, no taxes will be paid on the growth or the principle.
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