It’s a known fact that the cool folk don’t get to the party until after it’s started, and that fact remains with this retirement extravaganza. We are nearing the half way point (8:00pm, this is retirement after all) and who shows up to join the 401(k), none other but the Traditional IRA or Individual Retirement Account and his younger brother the Roth IRA, arguably two of the most popular and discussed retirement plans available today.
So what is it? The traditional IRA is very similar to the traditional 401(k); it is a plan that allows you to make pre-tax contributions to a retirement account lowering your taxable income; however it is not company sponsored, the account is opened individually outside of your employer. Institutions like banks (ex. Bank of America) or brokerages (ex. TD Ameritrade) are the main types of companies that offer IRA’s, which can usually be opened quickly and easily online.
How does it work? Once the IRA is set up through your chosen institution contributions can be made throughout the year to the account. It might make things a little easier if you think of the IRA like a type of savings account, all deposits are up to you, and if you don’t actively deposit money it won’t automatically happen for you, unlike a 401(k), unless you are able to set up direct deposit through your employer. Simple example: Joe has a taxable income of $50,000/year if he opens an traditional IRA and contributes $3,000 his taxable income will be reduced to $47,000/year.
Quick technical detail, because this account is set up outside of your employer, contributions made are actually after tax has been withheld from your paycheck. When you file your annual taxes a deduction is applied for the amount contributed to the plan, lowering taxable income the same amount as pre-tax contributions would have. There are multiple choices of where to invest funds contributed to an IRA, common investment options include, index funds, mutual funds, bond funds, and individual stocks (if a self directed IRA). Once you retire and begin withdrawing funds, those distributions are then taxed at the ordinary income taxes rates at that time.
Important information to note: an IRA is not like a normal bank account, it is governed by different laws and regulations. The biggest difference is you can not access your money whenever you want, because it is a retirement account you are not eligible to withdraw funds until you reach the age of 59½. Now, there are certain instances when funds can be withdrawn before this age but you could be subject to penalties or additional taxes. Each situation is unique; if you need to withdraw money early from your IRA it is best to speak with customer service where the account is held or a financial advisor. There are also limits to the amount you can contribute to the plan in a given year, for 2012 the limits are as follows
- $5,000 if younger than 50
- $6,000 if over 50
- If you file as single and make over $68,000 a year or file jointly and make over $112,000 you are ineligible for a tax deduction on Traditional IRA contributions.
Soooo what about that Roth IRA? A Roth IRA is very similar to the Traditional IRA except for a two key differences
- Contributions are made after tax instead of before
- The income limits for eligible contributions are higher.
Making contributions after tax means you receive a tax benefit in retirement instead of when the contribution occurs. When money is withdrawn in retirement there is no tax since it was already paid. The contribution limits in 2012 for a Roth IRA are as follows, if you file as single and make less than $110,000 or file jointly and make less than $173,000 you are entitled to make the full contribution of $5,000 or $6,000 if 50 or older.
Now many people want to know which plan is better, Roth or Traditional, and the truth is one is not “better” than the other in all cases. The choice of which plan to choose largely comes down to your individual tax situation, weather you prefer to pay taxes now or later, and your assessment of future tax rates, something very hard to determine.
Other notes about the Roth IRA: There are a few beneficial features of a Roth IRA worth mentioning.
- You can withdraw any contributions made to the IRA tax free at any time even before age 59½.
- For example if you have contributed $5,000 and earned $2,000 of interest since opening the account you would be able to withdraw up to $5,000 without penalty.
- If you are a 1st time home buyer you can withdraw up to $10,000 in principal and interest towards the purchase your first house (also applies to Traditional IRA).
IRAs can be hairy animals but you should now have the basics down, if you would like more information on Individual Retirement Accounts check out the two links below.
So do party with an IRA? If so, did you chose Traditional or Roth, and why? Leave your comments below, and if you learned something new hit the share button!
If you happen to be one of the cool folk that missed the first half too, don’t worry, click here to get brought up to speed on everything you missed.
So where do I actually open up a Roth IRA account? Do you have any advice on choosing the right bank or broker?
I’m actually in the process of doing this myself. First I plan on checking out each institution I bank or trade with to see what their options are. The two main things I am concerned with are the fees and investment options. The goal for me is to keep fees low and invest in a life cycle fund, which is a fund which will automatically reallocate between asset classes as your get older. It’s kind of like a set and forget it approach and is the same method I use for my 401k. So I would start with who you currently bank with and if you don’t like what is offered check out some of the major online brokers, Schwab, Etrade, TD Ameritrade, etc. looking for avg/low fees and ability to invest in index or life cycle funds.
I would think that the Roth IRA would be superior in the long run, based soley off the fact that the interest you earn is not taxed upon taking it out. So basically you put in $5,000 (which is taxed) but then get out $6,000 (which is not) basically skipping out of $1000 worth of taxes. Is this logic correct, or am I missing something?
If your investments earns $1,000 then yes your logic is correct. You would not have to pay taxes on that $1,000 in earnings. But do keep in mind that returns are not guaranteed, as with all investments there is some risk of loss.
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