Understand U.S. IRAs
October 14th, 2009
Make investing a little less taxing
In the U.S., an IRA (Individual Retirement Account) and its tax benefits can make an attractive investment. But which type is best for you--traditional, Roth, or education?Each has different tax advantages, different guidelines for eligibility, different allowable investment rates, and different types of penalties for withdrawing at different ages. We'll outline each type of IRA, and help you decide which will work hardest for you.An IRA pools people's money together and invests it. The combined investment generates profit and interest, which is divided among investors according to how much they put in. An IRA is set up so investors can direct their contributions (or different percentages of their contributions) toward safe or aggressive investment funds, depending on their individual
In the U.S., an IRA (Individual Retirement Account) and its tax benefits can make an attractive investment. But which type is best for you--traditional, Roth, or education?Each has different tax advantages, different guidelines for eligibility, different allowable investment rates, and different types of penalties for withdrawing at different ages. We'll outline each type of IRA, and help you decide which will work hardest for you.An IRA pools people's money together and invests it. The combined investment generates profit and interest, which is divided among investors according to how much they put in. An IRA is set up so investors can direct their contributions (or different percentages of their contributions) toward safe or aggressive investment funds, depending on their individual
long-term goals. In this way, it's similar to a 401(K) plan, but 401(K)s often feature the added investment of matching funds from employers. This 2torial only discusses IRAs. All money amounts given are in U.S. currency.
You'll find all types of IRAs offered by most banks and financial institutions. To search the Internet for IRAs in which you can invest, type the keywords "IRA application" into a search engine. This will move you past the general information IRA sites and connect you directly to financial institutions offering IRAs. If you have a specific financial institution in mind, type in its name and search its website for IRA options.
Understand a traditional IRA
What's today called the traditional IRA was introduced to U.S. citizens in 1981. It's a tax-deferred account, meaning most contributions and all earnings aren't taxed until you begin withdrawing them. As of 2000, an IRA can accept up to $2,000 in tax-deductible contributions per year ($4,000 for married couples) for any income level, although contributions to an employer retirement plan can limit this further. Individuals must also earn at least the amount they contribute. Here are the eligibility requirements, advantages, and limitations on withdrawals for a traditional IRA: Eligibility. If you aren't contributing to a company retirement plan, you can deduct taxes for the full amount you contribute to an IRA each year. If you participate in an employer retirement plan, you may still deduct the full or partial amount, or you may not be able to deduct anything. It all depends on your adjusted gross income (AGI). The highest AGI a person or couple can make while participating in a company retirement plan and still receiving partial deductions for IRA contributions increases slightly each year. Check with your financial institution or the IRS to determine how these parameters may affect your proposed contributions. Individuals married to spouses who participate in employer retirement plans but who do not participate in such plans themselves can contribute to an IRA and still receive full tax deductions. This advantage phases out if the couple's AGI is between $150,000 and $160,000. Note: If you make non-deductible contributions to your IRA, you won't be taxed again on these funds when you withdraw them. It's important to keep tax records so you can prove that tax has already been paid on these contributions. The contribution limit remains at $2,000 per year, though. Other advantages. Any tax deduction constitutes an advantage. Even if you don't qualify for tax deductions on contributions to an IRA, you still get tax-deferred growth. This means your earnings grow without taxation until you start making withdrawals. Over a period of 25 years or more, this "extra investment" can be a tremendous advantage. Limitations on withdrawal. If you withdraw funds from your IRA before you reach age 59 1/2, the funds are subject to a 10 percent penalty as well as ordinary income tax. Conversely, you must begin withdrawing funds from your IRA in required minimum distributions by April 1 of the year after you turn 70 1/2. Note: You can avoid the 10 percent penalty for early withdrawals only if you use the money for:
You also avoid the 10 percent penalty if early withdrawals take place because of the owner's death or disability.
Understand the Roth IRA
Roth IRAs were introduced as part of the Tax Acts of 1997 and 1998 as a means to further encourage long-term savings. All contributions to a Roth IRA are taxable, but all earnings and withdrawals made after age 59 1/2 are tax-free. Your Roth IRA must be established for five years or more to qualify for this advantage. Individuals may contribute $2,000 per year to a Roth IRA, and married couples may contribute up to $4,000. Here are the eligibility requirements, further advantages, and limitations on withdrawals: Eligibility requirements. Your income level must at least match your contribution to a Roth IRA. A Roth IRA contribution can also be made on behalf of a nonworking spouse or a spouse earning a low income. Roth IRA allowable contributions phase out for AGIs of $95,000 to $110,000 for single filers and $150,000 to $160,000 for joint filers. If a spouse makes less than $10,000, and his or her spouse is already contributing to a Roth IRA in their name, he or she can make only limited contributions to a Roth IRA. Other advantages. If you continue working after age 70 1/2, you may continue to contribute to a Roth IRA. There's no maximum age limit requiring withdrawals, unlike traditional IRAs, so you can continue to let your money grow, tax-free, no matter how old you are. Roth IRA contributions are also not affected by participation in employer-sponsored retirement plans. Limitations on withdrawals. If you withdraw funds before age 59 1/2, they'll be subject to a 10 percent penalty, and any earnings will also be subject to ordinary income tax. This can be avoided if withdrawals are taken after a 5-year holding period and are either used for a first-time home purchase or made after the death or disability of the owner. During the holding period, the funds must remain untouched, however. If you withdraw money from a Roth IRA before it's 5 years old, initial withdrawals will be considered as coming from the original, already taxed contributions--so they won't be taxed again, nor will they be charged the 10 percent penalty, even if you haven't reached age 59 1/2 yet. However, once you've withdrawn an amount equal to your contributions (leaving only earnings), you'll be taxed and charged a 10 percent penalty on any further withdrawals made before the Roth IRA reaches 5 years in existence. In this case (when the Roth IRA hasn't fulfilled a 5-year holding period yet), the owner won't be charged the 10 percent penalty if he or she is either over age 59 1/2, or using the funds for a first-time home purchase, or if the funds are withdrawn as a result of death or disability.
Compare traditional and Roth IRAs
When comparing traditional and Roth IRAs, here are some points to remember: Expense (and various uses) of initial contribution. To make a $2,000 contribution to a Roth IRA, a contributor in the 28 percent income tax bracket must earn $2,778 in order to pay tax on the contribution. For this same income ($2,778), $2,000 can be contributed to a traditional IRA, and the investor will have an additional $778 (about $560 after a 28 percent income tax is deducted) to invest elsewhere. The possible outcomes of this extra investment should be considered when comparing the outcomes of traditional and Roth IRAs. Present and future tax brackets. If you're thinking about a traditional IRA, consider the tax bracket you'll probably be in when you withdraw funds from it later in life. If the bracket will be considerably higher than your current one, it may be better to contribute to a Roth IRA, which imposes taxes when you contribute funds, but not when you withdraw contributions or earnings. Of course, this consideration is the opposite if you expect to be in a lower income tax bracket when you withdraw your money. Investment earnings taxes. The Roth IRA lets you defer taxes on a larger sum than the traditional IRA. This is because your investment earnings compound tax-free and remain tax-free at withdrawal after the 5-year holding period and age 59 1/2. This advantage will hold true as long as the tax rates when withdrawals are taken are the same as or higher than when the contributions were made. (Keep in mind the cost of the original contribution when comparing this advantage, however.)
Understand an education IRA
If you want to prepare for your child's education, you might prefer an education IRA. These accept non-deductible contributions on behalf of a child under 18 and allow the contributions to grow tax-free until the child for whom they're designated uses them for eligible postsecondary education expenses. Upon withdrawal, earnings aren't taxed if they're used for higher education expenses such as room, board, and tuition. Here are the eligibility requirements, further advantages, and limitations on withdrawals for an education IRA. Eligibility requirements. Parents, other relatives, friends of the family, and even the child him- or herself can contribute to an education IRA. Contributions are limited to an aggregate of $500 per year. Maximum contribution amounts are lowered for potential contributors with higher AGIs, specifically for single filers making $95,000 to $110,000 per year or joint filers making $150,000 to $160,000 per year. Advantages. As already mentioned, withdrawals from an education IRA are tax-free if they're used for qualified postsecondary educational expenses. You also have the option to roll over any remaining funds into an education IRA for another family member, which allows the earnings to continue growing, tax-free.
Limitations on withdrawals. If the earnings portion of an education IRA is withdrawn but not used for educational expenses, it's subject to applicable income taxes and a 10 percent penalty. Taxes and the penalty are avoided if the withdrawal is due to death or disability of the child for whom the IRA was intended, or if withdrawals occurred in the same year in which the beneficiary received a qualified scholarship. If there are still funds left in the account by the time the beneficiary reaches age 30 (or dies, if earlier), the funds must be withdrawn (the earnings will be taxed and charged a 10 percent penalty), or rolled over to an education IRA for another family member who is under 30. Whichever action you chose, it must take place within 30 days. Choosing an IRA and contributing to it can help you save and generate earnings for the future. In your golden years, or as your child goes off to college, you'll be glad you invested time to find the right IRA before you invested your money.
Understand a traditional IRA
What's today called the traditional IRA was introduced to U.S. citizens in 1981. It's a tax-deferred account, meaning most contributions and all earnings aren't taxed until you begin withdrawing them. As of 2000, an IRA can accept up to $2,000 in tax-deductible contributions per year ($4,000 for married couples) for any income level, although contributions to an employer retirement plan can limit this further. Individuals must also earn at least the amount they contribute. Here are the eligibility requirements, advantages, and limitations on withdrawals for a traditional IRA: Eligibility. If you aren't contributing to a company retirement plan, you can deduct taxes for the full amount you contribute to an IRA each year. If you participate in an employer retirement plan, you may still deduct the full or partial amount, or you may not be able to deduct anything. It all depends on your adjusted gross income (AGI). The highest AGI a person or couple can make while participating in a company retirement plan and still receiving partial deductions for IRA contributions increases slightly each year. Check with your financial institution or the IRS to determine how these parameters may affect your proposed contributions. Individuals married to spouses who participate in employer retirement plans but who do not participate in such plans themselves can contribute to an IRA and still receive full tax deductions. This advantage phases out if the couple's AGI is between $150,000 and $160,000. Note: If you make non-deductible contributions to your IRA, you won't be taxed again on these funds when you withdraw them. It's important to keep tax records so you can prove that tax has already been paid on these contributions. The contribution limit remains at $2,000 per year, though. Other advantages. Any tax deduction constitutes an advantage. Even if you don't qualify for tax deductions on contributions to an IRA, you still get tax-deferred growth. This means your earnings grow without taxation until you start making withdrawals. Over a period of 25 years or more, this "extra investment" can be a tremendous advantage. Limitations on withdrawal. If you withdraw funds from your IRA before you reach age 59 1/2, the funds are subject to a 10 percent penalty as well as ordinary income tax. Conversely, you must begin withdrawing funds from your IRA in required minimum distributions by April 1 of the year after you turn 70 1/2. Note: You can avoid the 10 percent penalty for early withdrawals only if you use the money for:
- Qualified higher education expenses
- Expenses related to the first-time purchase of a home (with a lifetime limit of $10,000)
- Medical insurance premiums when the investor has received unemployment insurance for more than 12 weeks
- Non-reimbursed medical expenses in excess of 7.5 percent of AGI
- A series of substantially equal periodic payments taken over the owner's life expectancy (usually in the case of a life-threatening diagnosis or accident)
You also avoid the 10 percent penalty if early withdrawals take place because of the owner's death or disability.
Understand the Roth IRA
Roth IRAs were introduced as part of the Tax Acts of 1997 and 1998 as a means to further encourage long-term savings. All contributions to a Roth IRA are taxable, but all earnings and withdrawals made after age 59 1/2 are tax-free. Your Roth IRA must be established for five years or more to qualify for this advantage. Individuals may contribute $2,000 per year to a Roth IRA, and married couples may contribute up to $4,000. Here are the eligibility requirements, further advantages, and limitations on withdrawals: Eligibility requirements. Your income level must at least match your contribution to a Roth IRA. A Roth IRA contribution can also be made on behalf of a nonworking spouse or a spouse earning a low income. Roth IRA allowable contributions phase out for AGIs of $95,000 to $110,000 for single filers and $150,000 to $160,000 for joint filers. If a spouse makes less than $10,000, and his or her spouse is already contributing to a Roth IRA in their name, he or she can make only limited contributions to a Roth IRA. Other advantages. If you continue working after age 70 1/2, you may continue to contribute to a Roth IRA. There's no maximum age limit requiring withdrawals, unlike traditional IRAs, so you can continue to let your money grow, tax-free, no matter how old you are. Roth IRA contributions are also not affected by participation in employer-sponsored retirement plans. Limitations on withdrawals. If you withdraw funds before age 59 1/2, they'll be subject to a 10 percent penalty, and any earnings will also be subject to ordinary income tax. This can be avoided if withdrawals are taken after a 5-year holding period and are either used for a first-time home purchase or made after the death or disability of the owner. During the holding period, the funds must remain untouched, however. If you withdraw money from a Roth IRA before it's 5 years old, initial withdrawals will be considered as coming from the original, already taxed contributions--so they won't be taxed again, nor will they be charged the 10 percent penalty, even if you haven't reached age 59 1/2 yet. However, once you've withdrawn an amount equal to your contributions (leaving only earnings), you'll be taxed and charged a 10 percent penalty on any further withdrawals made before the Roth IRA reaches 5 years in existence. In this case (when the Roth IRA hasn't fulfilled a 5-year holding period yet), the owner won't be charged the 10 percent penalty if he or she is either over age 59 1/2, or using the funds for a first-time home purchase, or if the funds are withdrawn as a result of death or disability.
Compare traditional and Roth IRAs
When comparing traditional and Roth IRAs, here are some points to remember: Expense (and various uses) of initial contribution. To make a $2,000 contribution to a Roth IRA, a contributor in the 28 percent income tax bracket must earn $2,778 in order to pay tax on the contribution. For this same income ($2,778), $2,000 can be contributed to a traditional IRA, and the investor will have an additional $778 (about $560 after a 28 percent income tax is deducted) to invest elsewhere. The possible outcomes of this extra investment should be considered when comparing the outcomes of traditional and Roth IRAs. Present and future tax brackets. If you're thinking about a traditional IRA, consider the tax bracket you'll probably be in when you withdraw funds from it later in life. If the bracket will be considerably higher than your current one, it may be better to contribute to a Roth IRA, which imposes taxes when you contribute funds, but not when you withdraw contributions or earnings. Of course, this consideration is the opposite if you expect to be in a lower income tax bracket when you withdraw your money. Investment earnings taxes. The Roth IRA lets you defer taxes on a larger sum than the traditional IRA. This is because your investment earnings compound tax-free and remain tax-free at withdrawal after the 5-year holding period and age 59 1/2. This advantage will hold true as long as the tax rates when withdrawals are taken are the same as or higher than when the contributions were made. (Keep in mind the cost of the original contribution when comparing this advantage, however.)
Understand an education IRA
If you want to prepare for your child's education, you might prefer an education IRA. These accept non-deductible contributions on behalf of a child under 18 and allow the contributions to grow tax-free until the child for whom they're designated uses them for eligible postsecondary education expenses. Upon withdrawal, earnings aren't taxed if they're used for higher education expenses such as room, board, and tuition. Here are the eligibility requirements, further advantages, and limitations on withdrawals for an education IRA. Eligibility requirements. Parents, other relatives, friends of the family, and even the child him- or herself can contribute to an education IRA. Contributions are limited to an aggregate of $500 per year. Maximum contribution amounts are lowered for potential contributors with higher AGIs, specifically for single filers making $95,000 to $110,000 per year or joint filers making $150,000 to $160,000 per year. Advantages. As already mentioned, withdrawals from an education IRA are tax-free if they're used for qualified postsecondary educational expenses. You also have the option to roll over any remaining funds into an education IRA for another family member, which allows the earnings to continue growing, tax-free.
Limitations on withdrawals. If the earnings portion of an education IRA is withdrawn but not used for educational expenses, it's subject to applicable income taxes and a 10 percent penalty. Taxes and the penalty are avoided if the withdrawal is due to death or disability of the child for whom the IRA was intended, or if withdrawals occurred in the same year in which the beneficiary received a qualified scholarship. If there are still funds left in the account by the time the beneficiary reaches age 30 (or dies, if earlier), the funds must be withdrawn (the earnings will be taxed and charged a 10 percent penalty), or rolled over to an education IRA for another family member who is under 30. Whichever action you chose, it must take place within 30 days. Choosing an IRA and contributing to it can help you save and generate earnings for the future. In your golden years, or as your child goes off to college, you'll be glad you invested time to find the right IRA before you invested your money.
Tags: death or disability, financial institution, further advantages, requirements, tax advantages, tax benefits, traditional IRA, tremendous advantage, vestors according
