Welcome back! Last week the blog was about the basic differences between Traditional IRAs and Roth IRAs. This week, I’ll get into more detail about how each works.
How much can I put in?
Traditional IRAs: You may contribute up to $5,500/year ($6,500 if you are aged 50 or over) and take a tax deduction on the contributions. Your ability to deduct the contributions goes away if you make too much money. The limits are $70k for Singles or $116k for couples who have a retirement plan at work, and $191k if you are married and do not have a retirement plan at work. See more details here: http://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits
Roth IRAs: The annual contributions are the same as Traditional IRAs, but no one may take a tax deduction on money added to a Roth IRA. There are income limitations to who may contribute to a Roth IRA. If you are single and make over $129k/year or married with income over $191k/year, you may not contribute to a Roth IRA. For info here: http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-for-2014.
How is the growth of the account treated for taxes?
Traditional IRAs: You don’t pay income taxes on the dividends, interest, and capital gains while money is in your Traditional IRA. When you withdraw, you will owe income taxes at whatever your tax rate is at the time. So, you don’t get out of taxes by using IRAs. Just kicking the tax can down the road. But still, it’s good because all those years of not paying taxes help you grow a larger nest egg.
Roth IRAs: Growth on Roth IRAs is tax free. That’s right, as long as you play by the IRS rules (see below), you can withdraw your Roth IRA money with no tax bill at all. Also, you can take your principal out of the Roth IRA at any time without taxes or penalties. For example, if you contributed $10,000 into a Roth IRA over 2 years and it grew to $12,000, you could take out the original $10,000 any time without taxes and penalties.
When can I take the money out?
Traditional IRAs: At age 59 ½ (Why the ½? Because our tax code is written by the Department of Demented Squirrels) you can withdraw money from your Traditional IRA and pay taxes on that amount. If you take out money earlier than age 59 ½, you’ll pay a 10% IRS penalty in addition to the income taxes.
Roth IRAs: The magic age to be able to withdraw from Roth IRAs and get the tax free benefit is also 59 ½ or 5 years after you started the Roth, whichever is longer. If you withdraw before that, your earnings will be taxed at your income tax rate and penalized 10% by your friends at the IRS.
What about Minimum Required Distributions?
Traditional IRAs: Because the government wants your money to be withdrawn and taxed within your lifetime, you must start taking money out of your Traditional IRAs by April 1st after the year you turn 70 ½. I know, AGAIN with the ½ year! What a pain!
Roth IRAs: Here, you get a break. Since the government won’t get any tax revenue from your Roth withdrawals, they won’t make you start taking distributions at any age. You can leave the money in your Roth IRA until death do you part.
Whew! Enough of that. Stay tuned for my next blog about the top 2 reasons people choose Roth IRAs over Traditional IRAs.