An Individual Retirement Account or IRA for short, is a type of investment account that allows investors to reduce the tax bill on the money that they are saving for retirement. The IRA is not the investment, but the account where the investments you make are held. There are several different types of IRA’s however the most popular are the Traditional IRA and the Roth IRA. Here is a table of the features and differences between a Traditional IRA and a Roth IRA. More detailed explanations are below the table.
|Feature||Traditional IRA||Roth IRA|
|When are you taxed?||When you take money out||When you put money in|
|Who Qualifies||Most people||Only people who make below a certain amount of money.|
|Contribution Limits||$5000 before age 50, $6000 age 50 and above.||$5000 before age 50, $6000 age 50 and above.|
|When can you withdraw?||age 59 ½||age 59 ½|
|Age Limit||70 ½||none|
|Early Withdrawal Penalties?||Yes. Income Tax on contributions and gains + 10%||On contributions: no.
On investment gains: yes. Income tax + 10%
|Best Option?||For most people no.||For most people yes.|
How do you open an IRA
Most financial institutions that offer investment products to individuals allow you to open an IRA. The process is very similar to opening a traditional investment account, and normally involves simply selecting that you want the account to be an IRA account when filling out your account application.
The benefits of an IRA
The main benefit of both a Traditional and Roth IRA is the ability to reduce the tax bill on the money you set aside for retirement. As the average federal tax rate for individuals (when taking out the top 1%) is around 24%, this is a huge savings which can dramatically increase investment gains.
The difference between a Traditional IRA and a Roth IRA
The primary difference between the two types of IRA’s is when you are taxed on the money you invest via your IRA account. Those who meet the requirements for contributing to a traditional IRA, do not pay taxes on the money they put into the account. They do however pay taxes on their contribution and any investment gains on those contributions when they withdraw the money.
With a Roth IRA it’s the opposite. You are taxed as you normally would be on money which is invested via the Roth IRA, but you do not pay taxes when you withdraw the money.
There are other differences such as how much you are allowed to contribute under different circumstances, when you can withdraw the money, and who is allowed to contribute. We go into detail on each of these points below.
Who can contribute to a Traditional IRA
Anyone who had taxable compensation during the year that is younger than 70 ½ at the end of the tax year can contribute to a traditional IRA. If you had no income but filed a joint return with your spouse who did, then you can also open an IRA. Compensation includes income you earned working for someone else or for yourself, alimony and separate maintenance, and nontaxable combat pay. It does not include earnings and profits on property, interest and dividend income, and pension or annuity income.
If you are also covered by a retirement plan at work (like a 401K for example) then you may not be able to deduct contributions made to a Traditional IRA, or you may receive a reduced deduction. This is also true if you are not covered by a plan at work, but you are filing a joint return with your spouse who is covered by a work plan. For more on this see the IRS’s table here.
Who can contribute to a Roth IRA
Unlike a Traditional IRA which you are not allowed to contribute to after age 70 ½, there is no age limit for Roth IRA contributions. Whether or not you or your spouse is also covered by a retirement plan at work is not a factor with a Roth IRA either.
There are however income limits that once reached either reduce or eliminate the amount you can contribute to a Roth IRA. The limits for the 2012 tax year are below:
You can find more detailed numbers here.
How much you can contribute to an IRA
For both traditional and Roth IRA’s there is a general limit of $5000 per year if you are less than 50 years old, and $6000 per year if you are age 50 or older. If you earned less than these amounts then you can contribute your entire income but cannot add additional money that was not classified as compensation.
If you are married and file a joint return then both you and your spouse can have an IRA even if one of you does not receive any compensation. The same limits apply so long as the non working spouse’s contribution is less than the working spouse’s income minus his or her IRA contribution.
When you can withdraw the money from an IRA
You can withdraw the money in both a traditional IRA and a Roth IRA anytime after reaching age 59 ½. If you are invested in a traditional IRA, then you are required to start taking distributions from the account at age 70 ½. There is no age limit as to when you must start taking distributions from a Roth IRA.
If you withdraw money from a traditional IRA before reaching age 59 ½ then you will pay income tax on the withdrawal plus a 10% early withdrawal penalty. For a Roth IRA you can withdraw the amount of your contributions before age 59 ½ without paying any additional tax or penalty. However, if you withdraw money you have earned on those contributions through your investments, the these earnings are subject to income tax plus the 10% penalties.
There are a few exceptions which can get you out of paying the early withdrawal penalty such as:
- Large medical expenses
- Up to $10,000 for the purchase of your first home
- Certain types of education expenses
Is a Traditional IRA or a Roth IRA better?
When deciding between a Traditional and a Roth IRA, the Roth IRA is almost always the better option. The reason why is that you can put the same amount of money into both the Traditional and the Roth, but because you don’t have to pay taxes on the withdrawals from the Roth your retirement account is effectively much bigger.
There are two primary possible exceptions which are:
- If you are going to reduce your contributions to the Roth IRA below your maximum contribution limit because you have to pay taxes on the contribution with the Roth.
- If you know that you are going to be paying a much higher tax rate when you are younger than when you start taking withdrawals on the Roth.
Many times, even if one of the above exceptions is true you will still be better off in the Roth as the ability to withdraw investment gains without having to pay taxes is a large enough advantage to offset them.