How Does an Individual Retirement Account Work?
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What is an Individual Retirement Account?
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An Individual Retirement Account -- technically, the term is "Individual Retirement Arrangement" -- is commonly referred to as an IRA. It is a personal retirement savings plan that gives the owner tax benefits designed to increase the amount accumulated for retirement. There are two types of IRA: the Traditional IRA and the Roth IRA. They differ in the way they give you tax breaks and in how you can contribute to them.
How to Open and Contribute to an IRA
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Anyone with earned income can open and contribute to a Traditional IRA. Up to certain income limits and with some other exceptions, the contributions are generally tax deductible, which means that the money invested is tax free in the year in which you contribute it. Only taxpayers who meet certain income requirements can open and contribute to a Roth IRA -- if you make too much, you may be disqualified from contributing. For 2012, the modified adjusted gross income cutoff for Roth contributions is $183,000 for married people filing jointly; for singles, it is $125,000.
This is the main difference: In general, contributions to a Traditional IRA are tax free in the year in which they are made, and their earnings grow tax deferred until you take them out, at which point all withdrawals are taxed as income. With a Roth IRA, your contributions are not tax deductible -- but they can grow tax free, and all withdrawals are tax free as well. With a Traditional IRA, you typically must wait until you turn 59 1/2 to withdraw your funds or you will face a 10 percent early withdrawal penalty along with income taxes on the full withdrawal. With a Roth, you can withdraw your direct contributions at any time without penalty, since the money has already been taxed, but earnings withdrawn before age 59 1/2 will likely face the 10 percent penalty plus tax. (The lone exception to the Roth contributions rule: contributions that are "converted" to the Roth from a Traditional IRA or some other kind of qualified retirement account must remain in the Roth for at least five years before you can withdraw the money without penalty.)
Contributions to a Roth IRA are not tax deductible, but they are more flexible than a Traditional IRA. You can make contributions to a Roth IRA when you are older than 70 1/2 years. A Traditional IRA forbids that.
There are limits on the amount you can contribute to Traditional IRAs and Roth IRAs in a tax year. For 2012, the limit stood at $5,000 a year to any combination of IRAs, or $6,000 if you are over 50. Check with the Internal Revenue Service for current limits and rules concerning the IRAs.
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Tax Benefits of IRAs
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A Traditional IRA allows you to deduct your annual contribution from your taxes in the year in which you contribute, as long as you meet certain income requirements. Your Traditional IRA then grows tax deferred. You do not pay taxes on the money in your Traditional IRA until you take distributions in retirement. Assuming you are in a lower tax bracket in retirement than while you were working, you will end up paying less in taxes. With a Roth IRA your contributions are taxed, but the account grows tax free and distributions are tax free upon retirement.
IRA Distributions
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A Traditional IRA requires you to start taking distributions at 70 1/2 years. You are not required to take distributions at any age with a Roth IRA. If you are older than 59 1/2 years and your Roth IRA has been open at least five years, you can take Roth IRA distributions tax free. Otherwise you will be charged a 10 percent early withdrawal penalty on the earnings. The IRS makes exceptions for higher education expenses, a first time home purchase, certain medical expenses, an IRS tax bill or the death of the account owner.
Converting a Traditional IRA to a Roth IRA
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The Roth IRA has been immensely popular since its introduction. Millions of investors have chosen to "roll over" their Traditional IRAs to Roth IRAs to take advantage of the long term tax advantages. When this is done, the Traditional IRA is cashed out and taxes are levied. Once the taxes are paid, the money can be deposited into a Roth IRA. It then grows there until distributions are taken. If they are qualified distributions, no taxes will be paid on the growth or the principal. Unlike direct contributions to a Roth, which can be withdrawn anytime without penalty, funds that are converted from a Traditional IRA to a Roth IRA must remain within the Roth for at least five years before you can withdraw them penalty free.
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