What Is an IRA? Traditional vs. Roth Accounts
An IRA is an individual retirement account (or arrangement). IRAs are investment accounts to help you save for retirement. They come with different tax benefits, depending on which IRA you set up. There are two main types of IRAs: traditional and Roth.
What Is a Traditional IRA?
With a traditional IRA, contributions made each year are tax-deductible. For example, if you contribute $6,000 for the year 2022 and are qualified. You can deduct that money from your taxable income. However, once you start to receive distributions, you will have to pay taxes on what you withdraw, including both contributions and investment earnings. This is ideal if you think you will be at a lower tax rate in the future.
Want to know if you’re qualified for a full tax deduction? Check out these links from the IRS to see if you qualify:
- If you are covered by a retirement plan at work
- If you are not covered by a retirement plan at work.
What Is a Roth IRA?
Unlike contributions to a traditional IRA, contributions to a Roth IRA aren’t tax deductible. However, Roth IRAs have a great benefit. When you start to withdraw from your account, the money is tax-free. Including what you earned on your investments. This is because the money you put in came after taxes were taken out of your paycheck. So you already paid them. If you think you will have a higher tax rate in retirement, this is the IRA for you.
Who Can Open and Contribute to an IRA?
You can open a traditional IRA if you (or your spouse, in the case of filing a joint return) received taxable compensation during the year and you aren’t age 70 1/2 by the end of the year. You can have a traditional IRA even if you have another retirement plan, like a 401(k). If both spouses have compensation, each person can open an IRA, but you can’t have the same IRA.
No matter what your age is, you can open a Roth IRA. In fact, you can open one for your child. But there are certain rules about who can contribute and how much depending on your income and filing status. To see if you can contribute to a Roth IRA, check the IRS Roth contribution rules.
What Are the IRA Contribution Limits? When Can I Contribute?
For 2022, if you’re under the age of 50, you can contribute up to $6,000. However, if you’re 50 or older, you’re allowed to contribute up to $7,000. This is so you can “catch up” if you didn’t contribute enough for retirement in the years before. If you contribute more than the maximum amount, the excess contribution is taxed at 6% for every year it remains in the account. To avoid the tax, all you have to do is withdraw the excess money (and any earned income from it) before your tax return is due.
Unlike most employer retirement plans, you have 15 months to contribute to your IRA. That’s three extra months! You can contribute for a given year up until your tax return due date. That means if you want to contribute for 2022, you have until April 15, 2023.
When Do I Have to Take Required Minimum Distributions?
A required minimum distribution (RMD) is the amount you withdraw from your IRA. For a traditional IRA, this applies once you are 70 1/2. Once you turn 70 1/2, you have to take your first distribution by April 1 of the following year. For example, you turn 70 1/2 on August 1, 2022. You must withdraw your first distribution by April 1, 2023. This applies to only your first RMD. After this, you have to take your distribution before the end of the year.
If you do not take your distribution or withdraw only a part of the required amount, any remaining distribution funds with be taxed with a 50% penalty. For example, if you’re required to take out $9,000 but you withdraw only $7,000. The remaining $2,000 will be taxed at a rate of 50%.
One of the benefits of a Roth IRA is that there is no RMD. The only time there is a requirement to withdraw funds is after the death of the account holder. Traditional IRA rules are then applied to the account and treated like the account holder died before their required distribution date.
Although Roth IRAs have no RMDs, distributions must be qualified to receive the tax-free benefit talked about earlier. This includes if the distribution is made…
- After the five-year period starting from the first taxable year a contribution was made
- On or after the date you turn 59 1/2
- Because you are disabled (as defined by the IRS)
- To a beneficiary or estate after your death
- For a first home (according to IRS guidelines, up to $10,000 lifetime limit).
For both traditional and Roth IRAs, there is a 10% tax for early distributions. To find out if your withdrawal is exempt from the tax, check the IRS early distribution exceptions.
Now that you have an understanding of IRAs, here’s a list with 77 other basic accounting terms. They can help you save money and make better financial decisions. We also provide a wide range of other financial literacy articles.
About Amber Deter
Amber Deter has researched and written about initial public offerings (IPOs) over the last few years. After starting her college career studying accounting and business, Amber decided to focus on her love of writing. Now she’s able to bring that experience to Investment U readers by providing in-depth research on IPO and investing opportunities.