Revisiting Traditional IRA and Roth IRA
For a lot of people, these two retirement planning accounts and their purpose can be a bit confusing.Many years ago I had to go over a few of my IRA related materials and have asked experts just to clarify a few things.
So let’s look at the origins of these IRA accounts and discuss them each in detail.
For starters, the best place to get information on them is directly at www.irs.gov and look up Publication 590-A.
Consider that your Bible for all things IRA. IRA stands for Individual Retirement Account. Let’s cover the basics!
The traditional IRA was established in the United States under the 1974 Employee Retirement Security Act (ERISA).
Before we go into the main features, it should be noted that a Traditional IRA is not an investment vehicle. It is the title to a retirement savings account.
Now, what the IRA invests in are the underlying investments. Consequently, the IRA custodian can be a bank, credit union, brokerage, or even insurance company.
From these, the investments can be very wide ranging, including self-directed IRA’s into gold, real estate and so forth that are beyond the scope of this article.
Just understand that the custodian is the holder of the investments.
So in a traditional IRA, the money contributed to it on an annual basis is either fully or partially deductible depending on your income.
Once the money is placed into the account, it will grow tax-deferred. This means you do not report as income any of the gains until you withdraw it.
It also means that you cannot claim any losses in the year during the tax deferral phase.
You can contribute up to $5,500 per year of earned income, or $6,500 per year if you are over 50 years of age. Spouses can also contribute to their own IRA as long as one of the spouses has earned income.
This is a total of $11,000 or $13,000 if over 50.
The contribution limit is across all IRA owned, not matter how many you have. There are other limits based on income and employer retirement plan contributions. Also, there are Modified Adjusted Gross Income limitations imposed as well.
As it is meant to be a retirement vehicle, there is a penalty, with some exceptions of withdrawals before age 59 ½. These exceptions are covered in the IRS Publication 590-A.
Any withdrawals before age 59 ½ outside of the exceptions, will result in the withdrawal being taxed as income and a 10% penalty.
On can continue contributing to their IRA up until age 70 ½. After that, it will be necessary to start taking withdrawals at what is known at the required minimum distribution rate.
This is because all of the money in this account has never been taxed, as it was deducted in the first place and the Federal Government wants their tax dollars.
Roth IRA’s were implemented as part of the Taxpayer Relief Act of 1997. Many of the features of the Traditional IRA are part of the ROTH IRA and we will cover the main differences.
A Roth IRA has the same contribution limits as the Traditional IRA with Adjusted Gross Income taken into account.
It is also reduced by any amount that you contribute to another Roth IRA or a Traditional IRA for that tax year. However, the contribution to the Roth IRA is not tax deductible.
The underlying investments allowed are the same as that of the Traditional IRA. However, since the money that goes into a Roth IRA is already taxed money, both the initial principal and any growth will come out tax-free upon withdrawal.
This makes it a valuable retirement income cash flow planning account.
The Roth IRA has to be established for at least 5 years before withdrawals can come out tax-free. You can contribute to a Roth at any age. Consequently, there is no 70 ½ age rule for withdrawals on Roth IRAs.
In Publication 590-A Table I-2 is a very nice chart on the comparison of the two IRAs! Here is our table:
|Traditional IRA||Roth IRA|
|Age 59 ½ penalty||Yes||NO (5-year rule)|
|Taxed on Withdrawal||Yes||No|
What has not been discussed here would be the rules for rolling Employer Income Reduction plans into Traditional IRA versus Roth IRA. What is a conversion?
What is a recharacterizing? What is an Inherited IRA and so forth! The laws surrounding both types of IRA’s can sometimes be complicated and every effort has been made to present factual information.
Any conflict with this article and the IRS rules governing will be deferred to the IRS rules as the higher authority.