Federal Tax Reporting For Ira Over 70 1 2 Old Major Differences Between Roth IRA & Traditional IRA

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Major Differences Between Roth IRA & Traditional IRA

Interestingly, there are 11 different types of IRAs, ranging from Individual Retirement Accounts, Employer and Employee Association Trust Accounts, Spousal IRAs, Rollover Conduit IRAs, etc. The most common are the traditional IRAs and the Roth IRA. In this article, we will explain the differences and similarities between the two.

Traditional IRA

In a Traditional IRA, the contributions you make to the account are not taxed. Whatever capital gains and income you make on your IRA are also not taxed until retirement, when you withdraw money from your account. For example, imagine you earned $50,000 this year and contributed $5000 to a traditional IRA. You will be taxed on $50,000 – $5000 = $45,000. In addition, your $5000 contribution will grow tax-deferred for many years, until you retire and decide to withdraw it. The downside with this is that your $5000 (which would likely have grown to $50,000 upon retirement) will then be taxed at your ordinary income tax rate.

Note: You can withdraw this money only after you turn 59 and 1/2 years or older. Any withdrawals made before this age will be subject to income taxes as well as a 10% early withdrawal penalty. However, if you use the withdrawn funds to finance college expenses or for the list of 8 exceptions below, you will not have to pay the 10% early withdrawal penalty.

8 Exceptions That Eliminate the 10% Early Withdrawal Penalty

There are 8 exceptions to the 10% early withdrawal penalty (ie withdrawals that are taken before age 59 and 1/2). They are for distributions that:

i) Are taken because of the IRA owner’s disability

ii) Are taken upon the death of the IRA owner

iii) Is a series of loan repayments made over the lifetime of the IRA investor

iv) Are used to pay unreimbursed medical expenses that exceed 7.5% of the IRA owner’s adjusted gross income.

v) Are used to pay for medical insurance premiums if the IRA investor is unemployed for more than 12 weeks.

vi) Are used to pay for the purchase of a primary residence (a maximum of $10,000 can be withdrawn). Also, the IRA investor must not have previously owned a home in the last 24 months.

vii) Are used to pay higher education expenses of the IRA owner or eligible dependents/family

viii) Are used to refund taxes from an IRS tax levied against the IRA

Traditional IRAs are often associated with the old way of investing: certificates of deposits. This stereotype is because most banks sell CDs and they are the ones that offer Traditional IRA accounts for investors. But remember, you are not limited to only investing in Certificates of Deposit or bonds, you can make higher risk investments like cyclical stocks, commodities, futures, ETFs, etc.

Traditional IRAs are often associated with the old way of investing: certificates of deposits. This stereotype is because most banks sell CDs and they are the ones that offer Traditional IRA accounts for investors. But remember, you are not limited to only investing in Certificates of Deposit or bonds, you can make higher risk investments like cyclical stocks, commodities, futures, ETFs, etc.

The Roth IRA

Started by the late Senator William V. Roth, Jr., the Roth IRA came into being on January 1, 1998 thanks to the Taxpayer Relief Act of 2007. The Roth IRA is unique from all other retirement accounts because all the earnings you accumulates on your savings will grow tax-free when you withdraw them after retirement. The only catch to this is that when you make the initial Roth IRA contributions, you won’t get any deductions on your income tax. Other advantages of the Roth IRA include the elimination of the minimum required distribution rule when you turn 70 1/2 years old (more on that below).

By making after-tax contributions to your Roth IRA, you won’t owe a dime of tax to Uncle Sam when you retire and withdraw your money. This adds the benefit of being able to grow your income tax free not for the government, but for yourself! So which retirement plan is the right choice for you? Well it depends on your personal situation. If you expect to be in a higher tax bracket when you retire, it’s better to pay the taxes now and grow your savings tax-free in a Roth IRA. Because a Roth IRA holds after-tax dollars, you can maximize your contributions by adding greater tax leverage to your retirement savings.

After-Tax Contributions

Consider Jackson, who earns a $65,000 annual salary. Jackson is currently in the 25% tax bracket and contributes $3500 per month to his Roth IRA. Jackson would therefore pay income taxes of $3500 x 25% = $875 and contribute $3500 – $875 = $2625 to his Roth IRA. If Jackson expects to be in a 33% tax bracket after retirement, he will have to pay $3500 x 33% = $1155 after his retirement. Therefore by making after-tax Roth IRA contributions now and getting taxed at the lower 25%, Jackson avoids having to pay taxes @ 33% when he hits retirement.

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