An individual retirement account is a tax-advantaged account designed to help you save for retirement. The two most common types—traditional and Roth—differ mainly in when you pay income taxes. With a traditional IRA, your contributions may reduce your taxable income in the present. For example, if you earn $60,000 and contribute $5,000 to the IRA, you may be taxed as though you earned $55,000. However, the money you withdraw from the IRA during retirement will be taxed as ordinary income. In contrast, with a Roth IRA, you contribute money that has already been taxed. In return, qualified withdrawals in retirement—including investment earnings—are tax-free.
Which should you choose?
Not everyone can freely choose between the two. Anyone with earned income can generally contribute to a traditional IRA, but whether that contribution is deductible depends on your income and whether you or your spouse participates in a workplace retirement plan. At higher income levels, the deduction may be reduced or eliminated. Roth IRAs have income limits that determine whether you can contribute. If your income exceeds the IRS threshold for your filing status, you cannot make a direct Roth contribution for that year. If you contribute despite exceeding the allowable limit, the ineligible amount is treated as an excess contribution and is subject to a 6% excise tax for each year it remains in the account. If you are eligible for both types of accounts, your decision will largely depend on timing. A traditional IRA may be more attractive if you expect your taxable income to be lower in retirement than it is now. Conversely, a Roth IRA may be preferable if you believe your future tax rate will be the same or higher. Thus your choice is primarily influenced by eligibility rules, followed by tax strategy.
Withdrawal rules and penalties
Both traditional and Roth IRAs are subject to early withdrawal rules. For traditional IRAs, distributions taken before age 59 1/2 are generally subject to income tax and a 10% early distribution penalty. The IRS provides various exceptions to this additional 10% penalty, although income taxes may still apply. Common exceptions include distributions used for unreimbursed medical expenses above the applicable income threshold, health insurance premiums while unemployed, qualified higher education expenses and a lifetime limit for a first-time home purchase. Certain military reservists called to active duty and individuals affected by federally declared disasters may qualify for penalty relief. Beneficiaries who inherit an IRA are generally not subject to the 10% early distribution penalty regardless of their age.
Roth IRAs have different rules. You can withdraw your contributions at any time without taxes or penalties since you have already paid taxes on that money. However, earnings may be subject to income tax and a 10% penalty if you are under age 59 1/2 or have not met a qualifying exception and if the account has not satisfied the five-year holding requirement. The five-year period begins on Jan. 1 of the year you make your first Roth IRA contribution. Rollovers to another IRA or a qualified retirement plan are not subject to the 10% additional tax if completed properly and in accordance with IRS rollover rules. There are also limits on how much you may contribute each year. The IRS sets annual maximum contribution amounts, with an additional catch-up contribution allowed for individuals age 50 or older. If you contribute more than the allowed amount, the excess is subject to a 6% excise tax for each year it remains in the account unless you correct it.
Required minimum distributions
Beginning at age 73—until 2033, when it becomes 75—owners of traditional IRAs are generally required to take annual required minimum distributions. An RMD is the minimum amount the IRS requires you to withdraw each year based on your age and the value of your account at the end of the previous year. This distribution is included in your taxable income, even if you do not need the money for living expenses. A qualified charitable distribution allows you to direct some or all of your RMD—up to the annual IRS limit—straight from your IRA to a qualified 501(c)(3) organization. The amount transferred helps satisfy your RMD but is excluded from your taxable income. This can be advantageous for taxpayers who do not need the full RMD for personal expenses and do not itemize deductions, as the QCD reduces adjusted gross income. A lower adjusted gross income may also reduce the taxation of Social Security benefits, decrease Medicare premium surcharges or limit exposure to other income-based phaseouts.
Estate planning considerations
IRA tax rules do not end at death. Beneficiaries who inherit IRAs are subject to distribution rules that may accelerate taxation. Because these rules can affect both income and estate planning strategies, it is essential to coordinate your IRA decisions with your accountant, financial planner, and estate planning attorney.
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