Understanding IRAs

IRAs can help you build substantial savings over time, and just about anyone who works can open one. There are two kinds: the traditional IRA (deductible and nondeductible) and the Roth IRA, with very different benefits.

In planning for your retirement, it makes sense to utilize every tax break Uncle Sam has to offer. One of the best: an Individual Retirement Account (IRA). Along with your retirement plan at work — if you’re lucky enough to have one — an IRA is one of the most efficient ways to build savings that have the opportunity to grow tax-deferred.

The big appeal of a tax-deferred account such as the IRA is that your money can grow more over time than it would in a taxable account. Say you deposited the maximum $5,500 in an IRA at age 40, then deposited the same amount every year for 20 years. Assuming a 6% return, your money would grow to $214,460 in those two decades — versus $180,307 in a taxable account.
The big appeal of a tax-deferred account is how much your money can grow, potentially, with compound interest.
Virtually anyone who works — for a company or for herself — can easily set up IRAs; most banks, brokerage houses, and mutual funds sponsor them. You have two main choices: the traditional IRA (a deductible or nondeductible version) and the Roth IRA. You’ll want to understand these different options before investing.
Traditional IRAs
With a traditional IRA, your contributions may be fully or partially deductible. These are the rules:

In 2014, if you have no retirement plan at work, you can contribute and deduct up to $5,500 ($6,500 if you are 50 or older). If you are participating in a retirement plan on the job, you can still take this deduction if your modified adjusted gross income is less than $60,000 (for a single person) or $96,000 (for a married couple, filing jointly). As a single person, you can get a partial deduction if your income is between $60,000 and $70,000; for a married couple filing jointly, it’s between $96,000 and $116,000.

For a nondeductible IRA, anyone with earned income is eligible to contribute.

You don’t pay taxes on the money until you start making withdrawals.

The earliest age you can take money out without paying a 10% early withdrawal penalty is 59½ (a few exceptions are available).

You must begin tapping a traditional IRA once you reach 70½. A complicated formula determines how much you must withdraw; you can find more about the minimum distribution requirements at the IRS website.
The Roth IRA
When you contribute to a Roth, you don’t receive an immediate tax deduction. Instead, your reward comes later, in the form of tax-free withdrawals at retirement. This is how it works:

Once you reach age 59½ and your Roth IRA has been open for five years, any withdrawal will be tax-free.

In 2014, you can fully contribute to a Roth if your modified adjusted gross income is less than $114,000 if you’re single or $181,000 if you’re married and filing a joint return. You can do a partial contribution if your modified adjusted gross income is less than $129,000 for a single or $191,000 if you’re married and filing jointly.

You’re not required to withdraw money starting at age 70½, as with a traditional IRA.

If you leave money in a Roth for your heirs, the money will pass to them tax-free.

As with a traditional IRA, if you withdraw money from a Roth IRA before age 59½, you may have to pay a 10% early withdrawal penalty (plus, ordinary income tax may apply). For the Roth IRA, contributions are always distributed tax-free, but the penalty may apply to earnings included in the distribution. The penalty does not apply — for the Roth IRA or the traditional IRA — in certain situations, however, including a withdrawal to buy a new home or for college expenses.
Go traditional, or Roth?
What may tip the balance in favor of a Roth, says tax analyst Mark Luscombe, is “if you expect to be in a higher tax bracket when you retire than you are now.” That means you’d be paying tax on the money at the lower rate, rather than when you start withdrawing. If you’re in one of the higher tax brackets now, you may want to go with a traditional IRA and pay taxes on the withdrawals later, ideally at a lower rate. To learn which account may be best for you, try this retirement tool.
Converting to a Roth IRA
What if you opened a traditional IRA in the past but now prefer the Roth? You may find you want to take advantage of the more-flexible withdrawal rules. Or maybe getting tax-free withdrawals in retirement will work better than the upfront deduction.

Whatever the reason, you have the option of doing a Roth conversion — that is, rolling over assets from a traditional IRA. You will have to pay taxes (at your current income tax rate) on the converted balance but not on future Roth IRA withdrawals.

If you do decide to convert to a Roth IRA, be aware that:

You must hold the money in a Roth for five years or until you turn age 59½, whichever comes first, to avoid penalties on withdrawals from the amount you converted. Each conversion has a five-year time limitation.

You’ll need to estimate your future tax rates if you are delaying the income, and be sure you have enough cash to pay the taxes due for converting. Consult your tax and financial advisor for help.

Key Points:

  • In a traditional Individual Retirement Account (IRA), your contributions may be tax-deductible, and your money has the potential to grow tax-deferred.
  • With a Roth IRA, you can make tax-free withdrawals during retirement.
  • You have the option of converting to a Roth if it becomes the more suitable option.

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