According to the Employee Benefit Research Institute, “Like never before, the American public is being reminded each day of the retirement challenges that lay ahead.” Despite that, many people are unprepared for taking on the important responsibility of understanding and planning for their increasingly hazy financial future. While there are a lot of different retirement plans, this month’s BFEC article provides a brief overview of the two simplest types of individual retirement arrangements, the traditional IRA and the Roth IRA.
In general, an IRA is a special account set up with a trustee or custodian (bank, credit union, S&L, brokerage firm, etc.) which allows an individual to set aside a portion of their annual compensation for retirement. According to IRS rules, “compensation” income includes wages, salaries, tips, professional fees, bonuses, and other amounts received for providing personal services. It also includes commissions, self-employment income, alimony and separate maintenance, nontaxable combat pay, and some scholarship and fellowship payments. However, it does not include earnings and profits from property, pensions and annuities (including Social Security), interest and dividend income, or income from certain partnerships.
For 2013, the maximum amount that can be contributed to an IRA is the lesser of $5,500 ($6,500 if you’re age 50 or older), or total taxable compensation for the year. However, if you are married filing a separate return or your modified adjusted gross income (AGI) is above a certain amount, your contribution limit may be reduced.
While there are several distinctions between Traditional and Roth IRAs, the two most significant are the tax treatment contributions get the year money is put into the account and the treatment distributions receive when taken out of the account.
A contribution to a traditional IRA is listed as an adjustment on the taxpayer’s return and will correspondingly lower the taxpayer’s income for that year. Because the net result is that no income taxes are paid on that contribution, it will be taxed as ordinary income when withdrawals are made during retirement.
A Roth IRA, on the other hand, does not provide a tax break the year money is placed into the plan; instead, the tax break is granted when the money is withdrawn from the plan during retirement. In other words, while Roth contributions do not reduce current income, assuming withdrawal rules are adhered to, distributions are tax-free.
Contributions can be made to either account throughout the year or in one lump sum. The deadline for making a contribution is April 15 of the year following the “contribution year,” i.e., while contributions can be made earlier, April 15, 2014 is the deadline for 2013 contributions. Further, under current tax law, depending on one’s filing status and adjusted gross income, contributions to either type of IRA may qualify for a Retirement Savings Contributions Credit (Saver’s Credit) of up to $1,000 ($2,000 if filing jointly).
Once funds have been deposited to a custodial IRA account, the investment options available to the depositor are limited only by IRS rules and the custodian’s charter. An IRA with a brokerage firm as custodian will provide the broadest array of investment choices: stocks, bonds, mutual funds, etc. A bank, credit union, or S&L account may be limited to Certificates of Deposit (CDs) or mutual funds; an insurance company may offer only mutual funds or annuities. Regardless of whether the account’s designated as a traditional or Roth, interest income, dividends, and capital gains accumulate without the burden of taxes.
Neither of these types of savings arrangements is intended for short-term savings. Generally, the amounts an individual withdraws from his or her IRA or other qualified retirement plan before reaching age 59 1/2 are called ”early” or ”premature” distributions and individuals must pay an additional 10 percent early withdrawal tax unless one of several exceptions apply. An additional requirement of a Roth account is that it must be held for five years before distributions are tax-free. Although contributions can continue to be made to a Roth IRA beyond age 70 1/2 and funds can be left in a Roth as long as the account holder lives, at 70 1/2 the owner of a traditional IRA can’t make additional contributions and must begin withdrawing funds.
This article’s been intended as a general overview of traditional and Roth IRAs. A more comprehensive explanation can be found in IRS Publication 590, via internet search, or by consulting your tax or investment advisor. Regardless of how you choose to become more knowledgeable of your options, keep in mind George Carlin’s quote: “The future will soon be a thing of the past.” Plan for your future sooner as opposed to later.
Members of the Bitterroot Financial Education Coalition, a project of the Bitter Root RC&D, will present a monthly column about personal finances.
The Bitterroot Financial Education Coalition is a partnership of Ravalli County organizations working to improve lives and strengthen our community by providing access to financial education that prepares individuals for life-long success in problem solving, decision making, and personal financial competence.