A traditional IRA is primarily an individual savings plan. Contributions are made up to a specified limit with the contribution tax deductible. Money invested and earned in a traditional IRA are subject to income taxes at the time of withdrawal. Withdrawals can be made without penalty once you reach the age of 59 1/2 years of age and you must begin withdrawing from your account when you reach the age of 70 1/2.
A traditional IRA must be set up with an IRS approved institution such as banks, some credit unions, brokerages, and so on. A traditional IRA can be established at anytime during the year but contributions for a tax year must be made before the owner’s tax filing deadline.
What are the Advantages of a Traditional IRA?
- Contributions are tax deferred
- Investment income is not taxed until it is withdrawn
What are the Disadvantages of a Traditional IRA?
- Premature withdrawals in excess of contributions are fully taxable and are subject to a 10% penalty
- Contributions are limited each year for each individual
- Withdrawals must begin when you turn 70 ½ years of age
- Failure to make withdrawals on schedule or not withdrawing enough money will result in penalties
- Contributions cannot be made after reaching age 70 ½
- Heirs will owe taxes on earnings
If you have more than one traditional IRA, they are treated as a single account when calculating the tax consequences of distributions from any of them. Early withdrawal of funds is subject to income taxes and a 10% penalty.
A Roth IRA is also primarily an individual savings plan. Contributions can be made up to a specified limit but are non-deductible on your tax form. Withdrawals are tax free within certain limitations. Withdrawals can be made without penalty once you reach the age of 59 ½ provided the funds have been in the account for 5 years. You can continue contributing to a Roth IRA even after you reach the age of 70 ½.
A Roth IRA must be set up with an IRS approved institution such as banks, some credit unions, brokerages, and so on. When you set up a Roth IRA, you will receive the IRA statement disclosure statement and the IRA adoption agreement and plan document. A Roth IRA can be established at anytime during the year but contributions for a tax year must be made before the owner’s tax filing deadline.
What are the Advantages of a Roth IRA?
- Contributions can be made after age 70 ½ (unlike the age limitation of a traditional IRA)
- Eligible individuals may contribute up to a specified limit annually
- Contribution eligibility is not restricted by active participation in an employer’s retirement plan
- Withdrawals after age 59 ½ are usually tax-free provided a 5 year wait has occurred
- No minimum withdrawal rules when you reach age 70 ½
- Heirs are not subject to taxes on earnings
What are the Disadvantages of a Roth IRA?
- Premature withdrawals in excess of contributions are fully taxable and are also subject to a 10% penalty
- Contributions are limited each year for each individual
- Tax rules could change
- Money must be left in the account for at least 5 years
- If you die, your heirs will have to follow the same minimum withdrawal rules as for a traditional IRA
If you have more than one Roth IRA, they are treated as a single account when calculating the tax consequences of distributions from any of them. To be tax-free, a distribution must meet both of the following requirements:
- the distribution must be made after the 5 year holding period
- the distribution must be made on or after the individual reaches age 59 ½, made to the individuals beneficiary or estate, made to the individual who has become disabled, or made for a first time home purchase
Traditional and Roth IRA Contribution Limits
Maximum contributions limits are the lesser of the annual dollar limit of the table below or 100% of earned income less contributions to IRAs.
The annual dollar limit is:
- 2017…. $5,500
For those who are age 50 and over before the close of the taxable year, the following annual limit applies:
- 2017…. $6,500
You can set up an IRA for your child’s education. The money you put into this IRA is taxed but the earnings are not taxed as long as the student withdraws the money to pay for qualified education expenses. The student is designated as the beneficiary and can make withdrawals at any time. Qualified education expenses include tuition, certain fees and supplies, books, and room and board. Check with the IRS or your financial planner for more information on education IRAs.
IRAs for Children
Did you know you can set up an IRA for your child or grandchild if he or she qualifies? To qualify to for an IRA, a person must have earned income from a job. This is an excellent way to teach a child the benefits of earning money and to help them with their retirement plans.
Putting money into a Roth IRA could provide even greater rewards.
This money grows tax-deferred and withdrawals at retirement are tax free. Suppose a child earns $3,000 each year for five years and contributes this amount to a Roth IRA each year. By the time he or she is retirement age, this $15,000 could be worth between $600,000 and $1,500,000 depending on growth rate. This money is tax-free at the time of withdrawal if it’s left until retirement age.
If your child or grandchild is working and you or they are planning to invest in an IRA, there are a few rules you must follow. Here is a check list:
- keep accurate and detailed records.
- if the child works odd jobs for neighbors, he or she should keep records of the dates, employer, and amounts paid for each job.
- if the child works for your family business, you should treat this as you would any other employee.
- if the child is self-employed, he or she should make sure they file the proper tax returns.
- be sure the child has earned income to match the contribution.
- be sure the employment is legitimate.
- know the difference in self-employment and a job.
You might have to shop around for an investment company that will open an IRA for a minor but once the child reaches 18, there should be no problems opening an IRA.
An IRA is an excellent way to save money. Whether you choose a traditional IRA, a Roth IRA, or an Education IRA, you will save money in the long run. A traditional IRA is tax-deferred until you reach retirement age and your contributions might be deductible from your income. A Roth IRA is not tax-deferred but you usually do not have to pay taxes on the earnings. An education IRA can provide money tax-free for your child’s education if you follow the rules.