The best way to explain these concepts is by asking some of the questions my clients ask me:
What is an IRA?
IRA stands for Individual Retirement Account, and it was created by sweeping pension reform act called ERISA in 1974. It is an account that can be designated to receive funds that accumulate tax-deferred growth. The original IRA concept, now known as a Traditional IRA, allows a taxpayer that qualifies to take a tax deduction up to a certain amount (currently $5500) with the understanding that it will not be touched until age 59 ½, after which distributions may be taken and they are included in income.
What about a ROTH IRA and what’s the difference?
The ROTH IRA was not created until 1997. All the features explained above apply to the ROTH also. But the big difference is tax treatment when it goes in and when it comes out. Like its cousin, the ROTH accumulates tax-deferred growth, but the taxpayer that made the contribution does not get a tax deduction, and unlike its cousin, the ROTH does not get taxed when distributed, assuming a few basic rules are observed.
What’s better, an IRA or a ROTH IRA?
We field this question a lot. The answer usually is: it depends. We advise clients to have buckets of both, but there are times when one may be preferable over the other. The variables are: your age at the time of contribution and expected retirement age; your marginal tax rate in the year of contribution; expected income needs and known income sources in retirement; composition of current portfolio assets, and whether retirement or non-retirement assets. This is just for starters. But, take heart: it doesn’t have to be so complicated to understand. It’s only math and it can be calculated.
What happens if take it out before I turn 59 ½?
Generally, unless you qualify under a small list of exceptions, this could be expensive money. For IRA’s, not only do you have to take it as income (remember you got a deduction when you put it and you promised not to touch it until 59 ½) but you will also pay a 10% penalty plus California adds another 2.5%. In some cases, we have seen total tax burden exceed 50%.
ROTH IRA distribution rules involve the need to have the account for at least 5 years, after which all withdrawals are tax-free (remember you did not get a deduction when you contributed). But even within the 5-year period, you do not get taxed on the principal you contributed, only the earnings.
In closing, please note that this is a high-level overview of the certain features of IRA’s and ROTH IRA’s. There can be numerous opportunities for you to discover tax efficiency through timely discussions with an objective advisor that knows your tax situation. Do you know of anyone?
In next week’s installment, we will discuss Part 3 – What to do if You Owe Money to the IRS