What is an IRA you ask?
Well, it stands for Individual Retirement Account. And it can be broken into several different types of IRAs. Today we are going to talk about one of the most common ones, the Traditional. The two most common being the Traditional and the Roth. We will tackle the Roth in the next episode.
There are several more types of IRAs that we will be discussing in future episodes among them being the SEP, Keogh, Simple and the newest addition to the family, the myRA.
The List of the Things You Must Know
- A Traditional IRA is a tax-advantaged account. Which means that you receive tax benefits from making contributions to your account.
- Contributions may be fully or partially deductible.
- Generally amounts in the Traditional including dividends, earnings and gains are not taxed until distribution. This means that your money will grow tax-free until you are required to start making distributions.
- Anyone receiving taxable income and is under 70 ½ may contribute to a Traditional IRA.
- Compensation that you are able to contribute from include wages, salaries, commissions, self-employment income, alimony, separate maintenance and non-taxable combat pay.
- Traditional IRA can be stand alone accounts or included in your 401k, which is managed by your employer.
- 401ks can have both types of accounts, Traditional or Roth.
- Contributions for the year are set at $5500 and $6500 if you are over 50. The contributions limits can change yearly so it is important that you research what amounts each year you are able to contribute.
- You can have more than one Traditional IRA. The total for all of your Traditional must equal $5500. So if you have 5 accounts you could contribute $1100 to each of them per year.
- Total contributions of you and a spouse can equal $11,000 or $12,000 if one of you is over 50. The total can be $13,000 if you both of you are over 50.
- Age 70 ½ rule is as follows. Contributions cannot be made to your Traditional IRA for the year in which you reach age 70 ½ or for any later that year.
- Deductions on taxes equal whatever you contribute up to $5500 or $6500 if you are over 50.
- The Traditional IRA was first established in 1974.
- The primary benefit is the-the amount of money to be invested is larger than would be with a post-tax ira such as a Roth. This means that the effect of compounding could have a great effect over time which will yield a larger return.
- While many people think that the reduction in taxes in the year of contribution is a benefit, that is not necessarily the case. While it is true that the unpaid taxes can be immediately invested and continue to grow, taxes on these gains will need to eventually be paid–either on an ongoing basis, if invested in a non-tax-deferred vehicle (e.g.if pre-tax options are already maximized), or at withdrawal otherwise. Assuming that both the tax deduction and the tax on its reinvestment gains only affect the individual’s top tax bracket, the results are tax-neutral. Any potential benefits of claiming and reinvesting a tax deduction come from the expectation that the taxpayer may be in a lower tax bracket during retirement.
- Unlike a Roth IRA, there is another plausible benefit (or penalty) equal to the reduction (or increase) in tax rates between the contribution and withdrawal, multiplied by the dollars withdrawn. Most taxpayers expect to be in a lower tax bracket in retirement. While the tax benefits from contributions are considered be at the contributor’s marginal tax rate, the withdrawals may add income at lower progressive tax brackets.
- With a Traditional IRA, one always has the option to convert to Roth IRA; whereas a Roth IRA cannot be converted back into a Traditional IRA.
- All withdrawals from a Traditional IRA are included in gross income, which is subject to federal income tax (with the exception of any nondeductible contributions; there is a formula for determining how much of a withdrawal is not subject to tax). This tax is in lieu of the original tax on employment income, which had been deferred in the year of the contribution. It is not a tax on the gains of said contributions while inside the account.
- Because taxes must be paid in cash in the account can be withdrawn and sued, this account is hard to use for emergencies. In some cases, there will be a fee from the bank or brokerage as well for withdrawing from a Traditional account.
- The size of an IRA account may mislead people into believing their wealth is larger than it actually is. The tax benefit from contributions is essentially a loan that mus be paid on withdrawal. This effect means that money saved in a Traditional IRA is not equal to money saved in a Roth IRA. Contributions to traditional IRA are from pre-tax income and contributions to a Roth are from after-tax income.
- Withdrawals must begin by age 70 ½ (more precisely, by April 1 of the calendar year after age 70 ½ is reached) according to a formula. If an investor fails to make the required withdrawal, half of the mandatory amount will be confiscated automatically by the IRS. The Roth is completely free of these mandates. This creates taxable income.
- In addition to the contribution being included as taxable income, the IRS will also assess a 10% early withdrawal penalty if the participant is under age 59 ½.
- The IRS will waive this penalty with some exceptions, including first-time home purchase (up to $10,000), higher education expenses, death, disability, un-reimbursed medical expenses, health insurance, annuity payments and payments of IRS levies, all of which must meet certain stipulations.
- A rollover (sometimes referred to as a 60-day rollover) can also be used to move IRA money between institutions. A distribution is made from the institution disbursing the funds. A check would be made payable directly to the participant. The participant would then have to make a rollover contribution to the receiving financial institution within 60 days in order for the funds to retain their IRA status. This type of transaction can only be done once every 12 months with the same funds. Contrary to a transfer, a rollover is reported to the IRS. The participant who received the distribution will have that distribution reported to the IRS. Once the distribution is rolled into an IRA, the participant will be sent a Form 5498 to report tax consequences of the initial distribution.
- Many tax deadlines fall at the end of the year. But there is an exception for IRAs. You can contribute up to the annual limit by the income tax deadline and still have the contributions count for the previous year. So if you don’t contribute to your IRA for 2015, you can still stash up to $5500 ($6500 if you’re 50 or older) for 2015 in a Traditional IRA by April 15, 2016. And if you want, you can contribute money for 2016 to your IRA at the same time.
We have talked about all the ins and outs of the Traditional IRA. And I hope you feel much more comfortable with how this can work for you. And how you can use this as another tool in your retirement toolbox.
The biggest thing to remember with the Traditional is that it is before tax money. Which gives you the opportunity for your investments to grow.
Next time we will discuss in depth the Roth IRA and how it could help you. If you have any questions, concerns or thoughts please let me know so that we can continue to learn more about IRAs and grow our knowledge around this important topic.
Until next time, take care.