IRA’s: What You Should Know
What is an Individual Retirement Account?
An individual retirement account (IRA) is a type of savings account that is designed to help you save for retirement and offers many advantages. There are two types of IRA accounts, traditional and ROTH. An IRA can be opened through a financial institution such as a bank, credit union, mutual fund company, or brokerage farm. IRA’s come with tax advantages, but the timing of the tax advantage for a Roth IRA is different from that of a traditional IRA. Since these products have advantages, the federal government has set limits on the amount of money that can be contributed each year.
Words Used Often
- Owner: This is the person who owns the individual retirement account.
- Disbursement: This is the payout of the individual retirement account; when the IRA funds are given to their owner.
- Contribution: This is the payment to your individual retirement account; the act of adding funds to the account.
- Conversion: This is the changing of a traditional IRA to a Roth IRA.
- Beneficiary: This is the person the owner of the individual retirement account names to receive the IRA funds in the owner’s stead. The owner chooses the person to receive their disbursement in case of the owner’s early death.
- Withdrawal: The act of taking funds out of one’s individual retirement account.
- Qualified Distribution: A payment or distribution from a Roth IRA that is tax- and penalty-free. A qualified distribution must meet specific requirements.
The traditional IRA has different forms: account and annuity. An IRA annuity is different because only one manager tracks it. An IRA annuity is not transferable by the owner. Also, the owner or the owner’s beneficiary must receive the distribution of the account. Contributions to a traditional IRA can be filed as either deductible or non-deductible. The advantage of the traditional IRA is that your deductible contributions and your earnings grow tax-free.
Roth IRAs came about in 1997 through the Taxpayer Relief Act. A Roth IRA is different from a traditional IRA because contributions are not deductible. The advantage IRAs is that earnings grow tax-free and qualified disbursements are also tax free. The Roth IRA shares the same maximum contribution limit as the traditional IRA.
The same largest contribution limit applies to both a traditional IRA and the Roth IRA. The maximum contribution limit is the smaller of $5,500 or the amount of taxable income. This limit can be split between a traditional and a Roth IRA, but the combined limit is $5,500. A “Catch-up Limit” is allowed for those who reach the age of 50 before the current taxable year. When this happens, a person can add an extra $1,000 to their normal contribution.
Traditional: When disbursed, the funds are generally taxed as ordinary income. When the owner of a traditional IRA reaches the age of 70.5, they must start receiving the required minimum distribution of their IRA.
Roth: Unlike the traditional, qualified distributions are not taxed as ordinary income. In fact, they are not taxed at all! If qualified distributions are received, then an owner does not need to include the distributions in their gross income.
Early Withdrawal Penalty
Traditional: Unless a qualified exception, you will pay a 10% penalty.
Roth: There are no penalties or taxes charged, as long as you take out only the contributed funds and leave the earnings.
An individual can transfer funds from a traditional into a Roth. This is known as a Roth conversion. Income taxes will be owed on the converted amount and must be paid in the tax filing year in which the conversion is made. A main reason for converting is that an individual expects to be in a higher tax bracket when they withdraw the money. Another reason is to leave money to heirs.
If you die before you received all of your individual retirement account funds, your IRA goes to the beneficiary(s) you have chosen. The beneficiary has several options to choose from depending on their wishes and the rules of the individual retirement account manager.
Which Should You Pick?
There are several factors to consider when deciding whether to contribute to a traditional or Roth IRA.
- If you think you will be in a higher tax bracket when you withdraw the money, it may be wiser to consider a Roth IRA.
- If you expect to be at a lower tax rate when you withdraw the money, you may want to consider a traditional IRA.
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Jana Hart- Extension Agent- FCS/4-H