What are Roth IRA and IRA Retirement Accounts?
What is an IRA?
IRA stands for Individual Retirement Account, and it is basically a savings account with big tax breaks, making it an ideal way to sock away cash for your retirement. A lot of people mistakenly think an IRA itself is an investment – but it’s just the basket in which you keep stocks, bonds, mutual funds, and other assets.
Unlike 401(k)s, which are accounts provided by your company, the most common types of IRAs are accounts that you open on your own. Others can be opened by self-employed individuals and small business owners. There are several different types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
Unfortunately, not everyone gets to take advantage of them. Each has eligibility restrictions based on your income or employment status. And all have caps on how much you can contribute each year and penalties if you yank out your money before the designated retirement age.
What’s the difference between Roth and traditional IRAs?
The main difference is when you pay income taxes on the money you put in the plans. With a traditional IRA, you pay the taxes on the back end – that is, when you withdraw the money in retirement. But, in some cases, you may escape taxes on the front end – when you put the money into the account.
Roth IRA
With a Roth IRA, it’s the exact opposite. You pay the taxes on the front end, but there are no taxes on the back end.
And remember, in both traditional and Roth IRAs, your money grows tax-free while it’s in the account.
Other differences
While almost anyone with earned income can contribute to a traditional IRA, there are income limits for contributing to a Roth IRA. Roth IRAs are more flexible if you need to withdraw some of the money early.
With a Roth IRA, you can leave the money in for as long as you want, letting it grow and grow as you get older and older. With a traditional IRA, by contrast, you must start withdrawing the money by the time you reach age 70½.
Roth IRA contributions are never tax-deductible, and you must meet certain income requirements in order to make contributions.
SIMPLE and SEP IRAs
SIMPLE and SEP IRAs are for self-employed individuals or small business owners. To set up a SIMPLE IRA an employer must have 100 or fewer employees earning more than $5,000 each. And the employer cannot have any other retirement plan besides the SIMPLE IRA. Any business owner or individual with freelance income can open a SEP IRA.
Withdrawals
Traditional IRA, you’ll be slapped with a 10% penalty on the amount you withdraw. Roth IRAs offer a bit more flexibility. Generally, you may withdraw your contributions to a Roth penalty-free at any time for any reason, as long as you don’t withdraw any earnings on your investments (as opposed to the amount you put in) or dollars converted from a traditional IRA before age 59 ½. In that case, you’ll get hit with that same 10% penalty.
Not sure which money is considered a contribution and which is considered earnings? The IRS views withdrawals from a Roth IRA in the following order:
- your contributions
- money converted from traditional IRAs
- then earnings
So if you take out more than you’ve contributed in total, then you’re starting to dip into conversion dollars or earnings, and will be penalized and taxed accordingly.
If you’re 59 ½ or older:
You can usually make penalty-free withdrawals (known as “qualified distributions”) from any IRA. But you’ll still owe the income tax if it’s a traditional IRA. To make qualified distributions from a Roth IRA, you must be at least 59½ and it must be at least five years since you first began contributing. And if you converted a regular IRA to a Roth IRA, you can’t take out the money penalty-free until at least five years after the conversion.
Exceptions to The RULE
Just to make it more confusing, there are several exceptions to these rules. If you’re 59 ½ or older you’re usually all clear. But if you’re younger than that, you will get hit with a penalty for early withdrawals from traditional IRAs, or early withdrawals on earnings from Roth IRAs.
But you can escape that 10% tax penalty if you’re withdrawing the money for a few specific reasons.
These include:
- Paying college expenses for you, your spouse, your children, or your grandchildren.
- Paying medical expenses that are greater than 7.5% of your adjusted gross income.
- Paying for a first-time home purchase (up to $10,000).
- Paying for the costs of a sudden disability.
Before making any withdrawals, please consult with a tax professional on possible tax penalties.
