These days, everyone thinks about retirement. Because social security isn’t designed to provide for all of your retirement needs, managing savings has become more and more critical. Whether you are just out of college and starting your first job, or you are a mid-career executive trying to diversify your portfolio, an Individual Retirement Account, or IRA, can be an important step toward retirement. Yet IRAs, which are highly regulated by the U.S. Government, can be a bit tough to understand. In this article, we will look at the two basic forms of IRAs and how they might benefit you as you plan for your golden years.
The Internal Revenue Service publishes a yearly publication about IRAs; the rules for these special savings accounts can be a bit daunting. For today, we will focus on the two main types of IRA accounts, called Traditional and Roth. (BankShout will discuss SEP IRAs, which are for self-employed savers, in a future article.)
Traditional
A Traditional IRA, like all IRAs, has contribution limits; as of 2009, if you are 50 or older, your contribution limit is $6000 or the amount of your taxable compensation for the year, whichever is smaller. (Savers under the age of 50 are restricted to a contribution limit of $5000 or the amount of taxable compensation.) Banks generally offer IRA accounts in the form of certificates of deposit, although their are other IRA forms as well.
The key benefit of a traditional IRA is tax deferment. When you make a contribution, it is tax-deductible; if you make $40,000 in 2010 and you deposit $5000 into a Traditional IRA, then you will only be taxed on income of $35,000. Of course, Uncle Sam wants his taxes–you’ll end up paying taxes on the Traditional IRA once you start to make withdrawals on the account. Because IRAs are designed for retirement, there are limits on withdrawals and typically you will be able to start making withdrawals once you reach the age of 59 1/2.
Roth
A Roth IRA has the same contribution limits as the Traditional. However, with a Roth IRA, the tax implications are different. Mainly, contributions are not tax-deductible. Yet at the same time, Roth IRA withdrawals are also not taxed. To prevent the Roth version from becoming a tax shelter rather than a true retirement plan, the IRS requires that a Roth IRA be open for a minimum of five years prior to you turning 59 1/2.
Although it may sound somewhat confusing, a Traditional IRA may also be converted to a Roth IRA. Why would you want to do this? You would need to pay taxes on the account at the time of conversion. Yet you may prefer to pay taxes at today’s rates, rather than tomorrow’s. Another key consideration is that of your income tax bracket, since a conversion can actually bump you into a higher tier. Previous rules limiting a conversion only to those with a certain tax filing status–such as gross adjusted income under $100,000–are being discarded in 2010, so if you didn’t qualify for a conversion in the past, you may want to revisit the idea. Calculators, like this one by BB&T Bank, can help you decide.
Summary
Some savers get a bit befuddled by all the rules surrounding IRAs. Yet anytime there are key tax savings available, it can be well worth the fuss. My advice is to ask your banker or personal financial advisor to recommend whether a Traditional or Roth IRA is right for you, or whether you might benefit from conversion to Roth from Traditional.
Kevin Fleming founded the CreditShout Network in 2008 to help people manage their credit and finances. Kevin wants to make it easy for anyone, regardless of their level of financial knowledge to understand banking and what may seem like the complex world of personal finance.
