The Truth About Traditional IRAs & Why Not to Invest
Financial journals may compare Roth IRAs and traditional IRAs, often touting the tax-free growth of the Roth over the tax-deferred growth of the traditional. Television and radio journalists add to the confusion with various investment options, problems with taxes and claims about the best solution for everyone. The problem is not with the traditional IRA structure; the problem is that a consumer is not aware of which IRA structure is best for his circumstances.
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Traditional IRA Definition
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A traditional IRA uses pre-tax dollars to save for retirement income. You must have earned income to make the contribution. The 2011 contribution limit is $5,000 annually, or $6,000 for people age 50 and older. Your income can exceed the contributed amount, but your income cannot be less than what you put in. So if you only make $3,000, you can only contribute up to $3,000. The contributions is deducted from income taxes, reducing annual income for the year. Normal distributions (withdrawals) start at age 59 1/2. These distributions are taxable upon distribution.
Better Tax-Deferred Option
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A better tax-deferred retirement savings option may be an employer-sponsored retirement plan. Employer plans include 401k and 403b plans. If your workplace offers either of these, you probably should contribute to it instead of to an IRA. One reason is the higher contribution limits. Both a 401k and 403b allow $16,500 in salary contributions per year. Not only are you able to contribute more, the employer might also match your contributions up to 6 percent of your income, essentially giving you a bonus for participating. Some employers also offer non-matching contributions on your behalf. Total contributions from employer and employee combined cannot exceed $49,000 annually.
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Tax-Free Options
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For some, a tax-free option is better than a tax-deferred option. This means the Roth IRA is better than the traditional IRA. The annual contribution is capped the same as a traditional IRA at $5,000 annually ($6,000 for people 50 and older). However, for employees covered by an employer's plan, income limitations might restrict the deductible of a traditional IRA, reducing its immediate tax benefit. Roth income limits are higher and not contingent on employer plans. Money is put into the Roth IRA based on earned income. There is no deduction on income tax returns, and the money grows deferred. Normal distributions start when two requirements are met: The owner must be at least age 59 1/2 rule, and the IRA must be owned for at least five years. Normal distributions are tax-free.
When to Use Traditional IRAs
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While the traditional IRA is not the best option for many consumers, it is the appropriate option for others. Speak with a tax adviser regarding your current and future tax scenarios. If taking a tax deduction now reduces your annual taxes more than what you would save from tax-free income in retirement, the traditional IRA is for you. For example, if you are at a 35 percent income tax bracket, you save $1,750 in taxes now if you qualify for a traditional IRA full deduction. If you anticipate only being in a 15 percent tax bracket in retirement, the $750 tax bill in a $5,000 distribution is considerably less. Each situation is different.
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