Types Of Individual Retirement Accounts

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Types Of INDIVIDUAL RETIREMENT ACCOUNTS

Yesterday we went over the basics of Individual Retirement Accounts, so today I want to tell you the types of IRA’s available to you.

Types of IRAs

When IRAs were first introduced, there was just one basic type, which was open to anyone with earned income. But since then, IRAs have evolved to include a number of variations:

Traditional:

There are two categories of tax-deferred traditional IRAs: deductible and nondeductible. If you qualify to deduct your contributions, you can subtract the amount you contribute when you file your tax return for the year, reducing the income tax you owe. If you don’t qualify to deduct, the contribution is made with after-tax income. The IRS website has resources to help you figure out whether, and to what extent, you can deduct your contributions.
Earnings on investments in a traditional IRA are tax-deferred for as long as they stay in your account. When you take money out—which you can do without penalty when you turn 59½, and are required to begin doing once you turn 70½,—your withdrawal is considered regular income so you’ll owe income tax on the earnings at your current rate. If you deducted your contribution, tax is due on your entire withdrawal. If you didn’t, tax is due only on the portion that comes from earnings.

You can’t contribute any additional amounts to a traditional IRA once you turn 70, even if you’re still working.

Roth:

Contributions to a Roth IRA are always made with after-tax income, but the earnings are tax-free if you follow the rules for withdrawals: You must be at least 59½ and your account must have been open at least five years. What’s more, with a Roth IRA you’re not required to withdraw your money at any age—you can pass the entire account on to your heirs if you choose. And you can continue to contribute to a Roth as long as you have earned income, no matter how old you are. Contribution levels for a Roth are the same as those for a traditional IRA. However, there are income restrictions associated with contributing to a Roth IRA. Both you and your spouse can each establish your own Roth IRA’s.

Spousal:

If you’re married to someone who doesn’t earn income (for example, if your spouse stays home with small children), you can contribute up to the annual limit in a separate spousal IRA in that person’s name as well as putting money into your own IRA. Your spouse owns the spousal IRA, chooses the investments and eventually makes the withdrawals. A spousal IRA can be a traditional deductible, traditional nondeductible or a Roth IRA, as long as you qualify for the type you select.

“Deemed” or Sidecar IRA’s:

In some cases, you can make contributions to an IRA through your employer by taking advantage of a deemed or “sidecar” IRA provision. In this case, your employer deducts your IRA contributions from your after-tax earnings. All the rules for this account—that is, for contribution limits, withdrawal rules and so forth—are the same as for any other IRA. If you qualify, you may be able to deduct your contribution when you file your tax return.

You might find a deemed IRA helps you to save. After all, contributions are automatic, so you don’t have to remember to write a separate check to your IRA custodian and you won’t be tempted to spend the money on something else. But you might also find that your choices of IRA investments are limited with this option, since they will depend on which financial services company your employer chooses as custodian or trustee of the account.

In addition, if you’re not keeping accurate records of your deemed IRA contributions, you might inadvertently go over the contribution limit, which remains the same no matter how many separate IRA accounts you have. That could mean incurring penalties.

Which Is Better: Traditional or Roth IRA?

The answer to this question will vary from person to person. Assuming you’re eligible to contribute to a deductible, traditional IRA or to a Roth IRA, here are some factors to consider:

  • Current- year tax benefits—Depending on your income and employment, contributions to a traditional IRA may be tax deductible, which reduces your taxable income each year you contribute. But if you don’t need that tax break now, a Roth IRA can give you more flexibility since you can withdraw your contributions at any time without paying taxes or fees—and you can withdraw your earnings tax-free if your account has been open at least five years and you are 59½ or older.
  • Likely future tax bracket—If you’re young and likely to be in a higher tax bracket when you retire, then a Roth IRA may make more sense. But if you’re likely to be in a lower tax bracket after you retire, a traditional IRA is usually the better choice. With a traditional IRA, however, you are subject to minimum required distributions when you reach age 70½.

Traditional Versus Roth IRA

 Traditional Roth
EligibilityMust have earned income of at least the amount contributed, except in cases of Spousal IRA.

No regular contributions allowed in the year you reach 70½ and older. The ability to take a deduction phases out if you earn more than $71,000 as a single taxpayer or $118,000 as a couple in 2016.

Rollover contributions allowed regardless of age.
Must have earned income of at least the amount contributed, except in cases of Spousal IRA.

May not contribute if you earn more than $132,000 as a single taxpayer or $194,000 as a couple in 2016.

IRA and rollover contributions allowed regardless of age.
ContributionsContributions may be made any time up to your tax filing date for that year (April 15 for most people).

For 2016, the contribution maximums are $5,500 if under age 50 and $6,500 if age 50 or older.

You may roll over (transfer) proceeds from a TSP or 401(k) plan into an IRA. (This does not affect contribution limits.)
Contributions may be made any time up to your tax filing date for that year (April 15 for most people).

For 2016, the contribution maximums are $5,500 if under age 50 and $6,500 if age 50 or older.

You may roll over (transfer) proceeds from a TSP or 401(k) plan into an IRA. (This does not affect contribution limits.)
WithdrawalsTurning 70½ years old triggers required minimum distributions from your traditional IRA.

A 10% tax penalty will apply to any withdrawal—of contributions, earnings or both—before you reach age 59½, unless you meet an exception set by the IRS.
You never have to take required minimum distributions from your Roth IRA.

Contributions can be withdrawn any time without taxes or penalty.

A 10% tax penalty will apply to any earnings you withdraw before you reach age 59½, unless you meet an exception set by the IRS. Also, a 10% tax penalty may apply if you take a distribution from a Roth IRA that has not been open for at least five years.
Tax DeductionsContributions may be tax deductible, depending on your income and whether you are covered by a retirement plan through your employer. Contributions are not tax deductible.
Other Tax BenefitsEarnings are tax deferred if withdrawn when you are 59½ or older. Earnings may be withdrawn tax free as long as the account has been open at least five years and you are 59½ or older.

Contributions can be withdrawn any time without taxes or penalty
Investment ChoicesDetermined by custodian or trustee holding your IRA.

Most custodians or trustees allow firm-approved stocks, bonds, mutual funds and CDs.
Custodians and trustees for self-directed IRAs may allow investments in assets such as real estate, private placement securities and some collectibles.
Determined by custodian or trustee holding your IRA.

Most custodians or trustees allow firm-approved stocks, bonds, mutual funds and CDs.
Custodians and trustees for self-directed IRAs may allow investments in assets such as real estate, private placement securities and some collectibles.

Taking Money Out

One important thing is true of all IRAs: Taking out money early is discouraged. In fact, you generally cannot make IRA withdrawals before age 59½ without paying an early withdrawal penalty. The penalty is 10 percent of the amount you withdraw. There are exceptions, however, if you take IRA money out to meet certain medical expenses, purchase your first home, pay college tuition bills or for certain other reasons listed in the federal tax laws. In any event, before you make any early IRA withdrawals, you should check with your tax or legal adviser to be sure you’re following the rules. Even if you do not face a penalty, you will have to pay income tax on any withdrawal you make. The only exception is that you can take up to $10,000 in earnings from your Roth IRA tax-free to buy a first home for yourself or a member of your immediate family, provided you have had the Roth for at least five years. There is a reason why withdrawing early from your IRA is made difficult. These savings vehicles are specifically designed to help you set aside money for retirement, not for other purposes. By imposing penalties for the early use of these funds, the government hopes that most people will leave their money alone. That way, the money will have time to compound, and will be available to support you in your retirement. You should be aware, too, that unlike certain employer plans, you’re not allowed to borrow against your IRA balance.

Required Withdrawals

Just as the IRA rules generally discourage you from taking your money out too early, other rules require that you begin withdrawing from a traditional IRA no later than April 1 of the year following the year in which you turn 70½. And once you do start taking money out, you must take at least your required minimum distribution, or RMD, every year. You’re always free to take more than the minimum, but you must take at least that amount, or risk paying a penalty. If you fail to keep up with your RMDs, you face a penalty that can be pretty steep: up to 50 percent of the amount you should have withdrawn but didn’t, plus the income taxes you would have owed on that amount. Don’t assume that if your IRA is invested in mutual funds, and you’re receiving distributions from those funds, that you’ve automatically satisfied your RMD. It could happen, but you can’t count on it. However, if your IRA is an individual retirement annuity, which you would set up with an annuity provider such as an insurance company, your annuity provider assumes the responsibility for ensuring that the income you receive from your annuity meets your RMD.

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