Individual Retirement Accounts- Simplified

Bag with dollar bills and the words Retirement on bagI thought it would be helpful to define what an Individual Retirement Account (IRA) is and the different types of IRAs that are available (in the most simplified way).

What is an IRA (Individual Retirement Account)?

Individual Retirement Accounts, or IRAs, are basically savings plans aimed for retirement with a number of restrictions. The main advantage of an IRA is that you defer paying taxes on the earnings and growth of your savings until you actually withdraw the money. The main disadvantage is the tax law imposes stiff penalties if you withdraw the funds before you turn age 59 1/2 years old. There are different types of IRAs, each with their own tax implications and eligibility requirements.

Traditional IRA

With a Traditional IRA, you get a tax deduction for the savings you contribute to the account. This deduction reduces your taxable income in the year of the contribution, and therefore, you are not paying tax on the income you set aside in a Traditional IRA. The savings grow tax-deferred, which means you won’t have to include interest, dividends, or capital gains from the IRA in your annual income. When you withdraw the money, the distribution from the IRA is included in your taxable income. It is taxed as ordinary income.

If you withdraw the money before reaching age 59 and a half, there is an additional 10% tax on that early distribution. In addition, you must begin withdrawing money from a traditional IRA beginning with the year when you turn age 70 1/2 years old (known as a required minimum distribution or RMD). There are restrictions on who can take a deduction for traditional IRA contributions.  If you or your spouse are covered by a retirement plan at work, your deduction may be limited or nonexistent.

Non-deductible IRA

A non-deductible IRA is a tax-deferred savings plan, just like the traditional IRA.  However, the contributions to the account are not tax-deductible. The savings do grow tax-deferred though. When you start taking distributions, part of the distribution will be a tax-free return of your original, non-deductible contribution, and the rest will be taxed as ordinary income. People usually opt for a non-deductible IRA when they are covered by a retirement plan through their employer but still want to contribute extra savings towards retirement. The only difference between a non-deductible IRA and a traditional IRA is the tax treatment of the original contribution.  You need to report this type of IRA yearly to the IRS with a separate form (Form 8606) which can get cumbersome and costly.

Roth IRA

A Roth IRA provides potentially tax-free savings and distributions.  Unlike a traditional IRA, you don’t get a tax deduction for your contributions.  The savings grow inside of the IRA without paying any taxes on the earnings and growth.  Distributions from a Roth IRA are completely tax-free, as long as you meet certain conditions. You can contribute to a Roth IRA even if you are covered by a retirement plan at work, but like all of the IRAs, there are income limitations for Roth IRAs.

Inherited IRA

It is an individual retirement account that is left to a beneficiary after the owner’s death.  If the owner had already begun receiving required minimum distributions (RMDs) at the time of his or her death, the beneficiary must continue to receive the distributions as already calculated or submit a new schedule based on his or her life expectancy.

If the owner had not yet chosen an RMD schedule or reached 70 1/2 years in age, the beneficiary of the IRA has a five-year window to withdraw the funds, which will be subject to income taxes.  A spouse who receives an inherited IRA can choose to roll it over into his or her existing IRA accounts with no penalties.  This option does not exist for non-spouse beneficiaries.

Tax laws surrounding inherited IRAs are quite complicated. Beneficiaries should seek the advice of a tax professional if they inherit an IRA. Be prepared for more changes in tax laws as the number of inherited IRAs keeps increasing.

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About Maureen Crimmins

Maureen Crimmins is co-founder of Crimmins Wealth Management and a fee-only independent financial advisor. Have a financial question? ASK MAUREEN

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