You’re certainly not alone if the words Individual Retirement Account (IRA) cause your mind to spin in confusion. The original IRAs were mind-boggling enough. However, now you have several options, including what many have called the “American Dream” IRA—the Roth IRA. Let’s take a moment and ferret out some of the nuances on the IRA landscape.
Nondeductible Traditional IRA.
This is the “plain vanilla” IRA. You simply write a check for up to $5,500 per year and you’re in. Your contributions are nondeductible, but the account earnings are tax deferred. If you need money before age 59½, you pay a penalty tax, except for first-time home purchases (up to $10,000); disability; medical expenses exceeding 10% of your adjusted gross income (AGI); and qualified higher education expenses. Likewise, at age 70½, contributions cease and mandatory minimum withdrawals must begin. While you are not taxed on the money contributed (that has already been taxed), your accumulated earnings are taxed as ordinary income upon withdrawal.
Every situation is unique.but this is perfect for:
People who have maxed out all the retirement accounts and are looking to put away more money on a tax deferred basis. This can also be used for a Roth conversion down the line.(we will talk more about this in a future post).
Deductible Traditional IRA.
Contributions to these IRAs are tax deductible up to $5,500 annually. However, if you or your spouse are active participants in a retirement plan or exceed certain income levels, your contribution may be restricted. As with the nondeductible IRA, your earnings are tax deferred, but because both contributions and accumulations have never been taxed, all withdrawals from your IRA are taxed as ordinary income. Also, the penalties for early withdrawals and the itemized exceptions are the same as nondeductible IRAs. Likewise, mandatory minimum withdrawals must commence at age 70½.
Every situation is unique but this is perfect for:
People who do not have a company retirement plan available, looking for tax deductions and need to save for retirement.
Roth IRA.
While the maximum nondeductible contribution remains at $5,500 per person, the Roth IRA has other potential advantages over existing IRAs. Generally, the adjusted gross income limit for single and joint filers is more than double for that of traditional IRAs. In addition, distributions of earnings are tax free, if you’ve maintained your account at least 5 years and are older than age 59½. Under appropriate circumstances, you may withdraw your contributions without penalty and income taxation prior to age 59½. Another advantage is contributions may be made for life and no withdrawals have to be made until one year following the death of the participant.
Every situation is unique but this is perfect for:
People who want tax free growth, fall UNDER the income limits, and are already contributing to a company retirement to get the most free money from their employer.
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| Current IRA balance: | $0 | Estimated annual rate of return: | 7% |
| Annual contribution: | $5,500 | Estimated income tax before retirement: | 35% |
| Years until retirement: | 30 Years | Estimated income tax at retirement: | 28% |
Result at retirement: Value of Roth IRA: $519,534. After-tax value of traditional IRA plus taxable account: $492,503.
Assumptions:
The same annual contribution is made at the end of each year until retirement. Earnings are compounded annually.
This illustration assumes that all traditional IRA contributions are fully tax deductible. However, note that if either the IRA owner or the IRA owner’s spouse participates in an employer-sponsored retirement plan, the deductibility of contributions is subject to limitations based on tax filing status and modified adjusted gross income. This illustration assumes that an amount equal to the tax deduction each year is invested in a taxable account.
Withdrawals from traditional IRAs are subject to federal income tax to the extent that they consist of deductible contributions and investment earnings. Withdrawals made before age 59½ may also be subject to a 10 percent penalty.
Contributions to a Roth IRA are not tax deductible. Depending on an individual’s tax filing status and modified adjusted gross income, allowable contributions to a Roth IRA may be limited.
Qualified distributions from a Roth IRA are not subject to federal income tax. Nonqualified withdrawals of earnings before age 59½ may be subject to income tax and a 10 percent penalty.
Note: This is a hypothetical example and is not intended to reflect the actual performance of any specific investment, nor is it an estimate or guarantee of future value. Investment fees and expenses, which are generally different for taxable and tax-deferred investments, have not been deducted. If they had been, the results would have been lower. The lower maximum tax rates on capital gains and qualified dividends, as well as the tax treatment of investment losses, would make the taxable investment more favorable than is shown in this chart. When making an investment decision, investors should consider their personal investment horizons and income tax brackets, both current and anticipated, as these may further impact the results of this comparison. All investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful.
Final Words
In a world where many clamor for tax simplification, you may find that retirement planning is also complex. Therefore, an IRA may prove even more attractive for its versatility and ease of implementation. Because Congress has provided many options for individuals and small businesses to install retirement plans, you may find the “right” Individual Retirement Account to fulfill your objectives.
As always, you can consult with me to discuss your IRA and retirement planning.
Look for future posts on the life insurance planning and check out my recent post on 8 horrible investing mistakes.
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Thanks for stopping by and I hope you achieve financial success!
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