The term IRA stands for Individual Retirement Account. These types of tax advantaged accounts are used by investors as a source of saving for retirement. There are two primary types of IRAs – these are Traditional and Roth.
Any investor who has earned income can participate in a traditional IRA. However, there are some stipulations as to how much of the IRA deposit can be deducted on the investor’s tax return.
There are also certain income limits on an investor’s modified adjusted gross income, although regardless, all IRA investors may still take advantage of the tax deferred growth of their traditional IRA funds.
Therefore, most traditional IRA accounts allow their owners to:
- Save money on a pre-tax basis
- Have the funds in the account to grow tax deferred
- Deduct from the account owner’s income – based on income level and tax filing status
In order to set up a traditional IRA, investors must qualify based on:
- Age – A person must be under age 70 1/2 in order to contribute to a traditional IRA account.
- Income – A person must have earned income of at least equal to or greater than their IRA contribution amount.
Due to their tax advantaged status, there are also maximum annual limits on the amount that an investor may contribute to a Traditional IRA.
- These limits are typically subject to change each year
- Additional contributions, however, may be made in addition to the annual maximum if the funds come from certain other types of qualified retirement accounts such as a 401(k) from a former employer
- Those who are age 50 and over may also contribute an additional amount of “catch up” contribution each year
With just a few exceptions, the IRS also places some guidelines upon when funds may be withdrawn from a Traditional IRA account. In most cases, if an investor withdraws money from a Traditional IRA account early (i.e., prior to turning age 59 1/2):
- They will be taxed at their income tax rate on the amount that is withdrawn
- They will also be subject to a 10% penalty on the full amount of that withdrawal if they are under age 59 1/2
Likewise, there are also rules as to when an investor must begin withdrawing funds from their Traditional IRA account. These are referred to as the Required Minimum Distribution, or RMD, rules. As such:
- Funds must begin coming out of a traditional IRA account when the investor reaches age 70 ½
- Failure to comply will subject the account owner to IRS penalties for not taking their required minimum distribution amount
Traditional IRA accounts can be a great way for investors to:
- Take an active role in their retirement savings
- Increase retirement assets using tax advantaged strategies
Investors of nearly any age and income level are allowed to open and fund a Roth IRA account, although there are some stipulations as to the amount of those contributions on an annual basis, as well as guidelines for the maximum amount of annual modified adjusted gross income of the account owner.
The funds that are in a Roth IRA are tax advantaged in that they are allowed to:
- Grow and accumulate tax free
- Be withdrawn without taxation as well
The rules for opening a Roth IRA account are not as stringent as they are for opening a Traditional IRA account. In order to qualify to open a Roth IRA, investors must:
- Earn some form of income or compensation
- Be of no particular age
If eligible for an account, investors are allowed to:
- Contribute funds to a Roth IRA using after tax dollars
- Withdraw funds at retirement free from federal income taxation
There are rules as to how much money an investor may deposit into a Roth IRA account each year.
- These maximum amounts typically increase every year
- Investors may contribute additional money, however, if the funds come from certain other types of qualified retirement accounts such as a 401(k) from a former employer (i.e., such as in a rollover situation)
There are IRS guidelines as to when an investor may withdraw funds from a Roth IRA account without penalty. For example:
- Contributions to a Roth IRA may be withdrawn tax free and penalty free
- Should any earnings from the account be withdrawn prior to reaching age 59 ½, then the investor may be subject to an IRS penalty of 10% of the amount of earnings that have been withdrawn.
- Qualified distributions may be made after a 5-year period starting with the first taxable year that a Roth IRA contribution was made by the account holder.
- >>>>> 2014 IRA Fact Sheet
Roth IRAs are unlike Traditional IRAs in that:
- There are no mandatory withdrawal requirements at any age
- Funds may be left in a Roth IRA account for an indefinite amount of time – even after the account owner turns age 70 1/2
However, withdrawals from a Roth IRA account are required to be made upon the death of the Roth IRA account holder.