Traditional Individual Retirement Account (IRA)
A Traditional Individual Retirement Account (IRA) is a tax-advantaged arrangement that allows earnings and deductible contributions to grow tax-deferred.
Tax advantages
Contributions may be deductible from your gross income on your federal income tax return for the year in which the contributions are made. Earnings grow on a tax-deferred basis. Deductible contributions and earnings are subject to federal income tax when withdrawn. (If you live in a lower-tax state when you withdraw contributions, you also save money on state income taxes.)
Eligibility requirements
You must not attain the age of 70 ½ during the year you contribute to a Traditional IRA. You must also have earned income (compensation) in order to contribute to a Traditional IRA.
Annual contribution limits
In tax year 2012, you can make annual contributions to a Traditional IRA of up to $5,000 or 100% of your earned income, whichever is less. For individuals over the age of 50, a contribution of up to $6,000 is permitted. An aggregate of $10,000 can generally be contributed per married couple ($5,000 per IRA) provided that either you or your spouse has earned income of at least that amount. The $5,000 and $10,000 annual contribution limits apply to the combination of all of your Traditional and Roth IRAs.
In tax year 2013, after several years without an increase to the traditional and Roth IRA regular contribution limit, there will be a $500 increase. The IRA contribution limit will increase to $5,500 with a catch-up contribution of $1,000. For individuals age 50 and older, the contribution limit will be $6,500.
If you are age 50 or older, you may make additional "catch-up" contributions to your IRA. Over the next several years, the maximum annual contribution amount will increase.
Note: Additional "catch-up" contributions have been included in amounts shown for age 50 or older.
Distribution guidelines
You may take distributions from a Traditional IRA starting at age 59½ - distributions taken before then are subject to taxes and tax penalties, unless taken for a qualified exception. You may take distributions in specific amounts, as a lump sum, or as a series of systematic payments. Distributions are taxed at ordinary income tax rates for the year the distribution was made. You are required to start taking distributions from your IRA by April 1 of the year following the year in which you reach age 70½.
The amount of your annual contribution to a Traditional IRA that can be deducted from your federal income taxes is dependent on two factors. These factors are whether or not you or your spouse participate in an employer sponsored retirement plan and the amount of your adjusted gross income as determined on your federal income tax return. The following scenarios should help you determine whether or not your contributions are deductible:
- If you (and your spouse) do not participate in an employer sponsored retirement plan, your contributions to a Traditional IRA are fully tax deductible, regardless of the amount of your adjusted gross income.
- If you (and your spouse) participate in an employer sponsored retirement plan, your adjusted gross income level will determine how much of your contribution is tax deductible. The following table should help you determine the deductible amount:
Roth IRA
A Roth IRA is an Individual Retirement Account that provides tax-free growth. As a result, it's the simplest - and potentially the most effective - sheltered account imaginable.
The Roth Tax Advantage
Like a deductible IRA, Roth gives you the advantage of getting taxed only once, rather than twice (or more) as with a regularly-taxed investment account.
- The Roth IRA is simple: it requires no special reporting to the IRS. (With a deductible IRA you have to report a deduction on your 1040 form when you make a contribution; on withdrawals you report the entire withdrawal amount as taxable income.)
- Roth has an extra advantage if you think taxes will probably rise in the future, since you're paying now rather than later. (Of course that's a disadvantage if you think taxes will fall.)
Here is a summary of how it works: |
You pay income tax, and then make your contribution with post-tax dollars Your principal may be subject to taxes on dividends and capital gains as it grows You pay capital gains tax on your gain at withdrawal | You get a tax deduction, essentially letting you deposit pre-tax dollars Your principal grows tax-free You pay income tax on the entire amount of your withdrawal | You pay income tax, and then make your contribution with post-tax dollars Your principal grows tax-free You pay no further taxes on withdrawal |
Roth IRA contribution limits
IRAs were created to encourage people to save for their retirement, by offering them a significant tax break. They are intended for ordinary working people.
The rules for limits change every year. You can (and should) get the official rules from IRS Publication 590.
- If your status is Married Filing Separately you are effectively locked out due to an extremely restrictive limit. (The rationale: the government doesn't want to give you a tax break in case your spouse is high-income. The exception: if you and your spouse lived apart for the whole year, you get the same limits as a Single filer).
- If your status is anything else, then your contribution limit is (using 2012 numbers):
- $5,000 if your income is low enough (and $6,000 if you're 50 or older)
- Zero (that is, you can't contribute at all) if your income is too high
- A sliding scale somewhere in between, if your income is somewhere in between "low enough" and "too high"
- In case you have multiple IRAs, the limit is the total you are allowed to contribute to all of them.
- And in all cases, your total contributions can't be greater than your reported salary income.
Penalties
An IRA is intended to be a retirement account, and so penalties apply if you misuse it by withdrawing funds too early. As a rule, you should plan not to make any withdrawals until at least age 59½ or five years after you make your first contribution, whichever comes later.
All information contained herein is intended to act as a guide in giving you an estimated allowable contribution limit. Contact your tax advisor for further information.