As summer time draws to an end, we thought it fitting to take a step back and get back to the basics for a little bit. Over the next couple weeks we’ll be getting down to the fundamentals of retirement plans and self-directed investing.
Whether you are just getting in to the world of self-directed IRAs or you are a veteran of many years, it’s always good to make sure you are on solid ground with your understanding of your retirement funds.
One of the most common questions that we get regarding retirement plans is “Which IRA is right for me?” And while we can’t replace your CPA or financial advisor, we can give you some information to help you make an informed decision.
The two most common types of IRAs are the Traditional and Roth. We’ll be focusing on these two in Part I of this series. There are a few more plan types available, but most people will find a fit with the Traditional or the Roth.
Finding the Common Ground
To start things off, let’s talk about how these two plans are similar, because in many ways the rules that apply to one will apply to the other.
As with just about any retirement fund, you need earned income to contribute to either plan. Earned income is simply income that you receive as wages or compensation for services performed. The most common examples are W-2 from your paycheck, 1099 income if you are a private contractor or Schedule C income if you are self-employed. Passive income, such as rental, dividends or interest, does not qualify as eligible income for a contribution to an IRA.
Both plans also have certain limits set by the IRS on how much you can contribute to the account on a yearly basis. The limits have increased regularly for many years and are now directly tied to inflation. For 2009, this limit is $5,000 ($6,000 if you are over age 50) per person for both plans.
The last parallel comes in the form of taxes on the account itself. In general, neither IRA will file a tax return or pay any sort of tax on a yearly basis.
The All-Important Differences – Taxes
Taxation of funds when contributing and when withdrawing is perhaps the most significant difference between the plans. With a Traditional IRA, you contribute on a pre-tax basis. This means that any contribution you make may be a tax deduction for you at the end of the year. Certain individuals with high income won’t qualify for this deduction.
And because you take your tax deduction going in to the account, you are taxed at your normal income tax rate when you withdraw funds in retirement. You get the immediate benefit of a tax deduction today and pay your taxes at a later date, when most people are in a lower tax bracket.
The Roth IRA gives you exactly the opposite benefit. Contributions are made on an after-tax basis and will never qualify for a deduction. But, by paying your tax up front, you can make qualified withdrawals completely income tax free. A qualified withdrawal is any distribution of funds made after you reach age 59 ½ and the account has been open for five years.
As a side benefit, because you paid your taxes on the contributions, you can withdraw funds up to the amount of your contributions tax-free at any time, even before retirement.
A requirement to take distributions is also an area where these accounts differ. The IRS says that at 70 ½ you must start taking a predetermined amount out of your Traditional IRA on a yearly basis. The goal being to exhaust the account within your lifetime. This is called a Required Minimum Distribution (RMD).
The Roth IRA has no such requirement though. With a Roth, you can keep the money you built up in the account in the tax-free environment as long as you wish. You can even pass the account to your heirs so that they, too, can benefit from the tax-free income it provides.
There’s Always a Catch
With all the benefits that come with a Roth IRA, you might be wondering why everyone doesn’t have one. The answer is because the IRS has said that they won’t allow certain people to contribute or convert to, a Roth IRA.
To make a contribution to a Roth IRA, your Modified Adjusted Gross Income (MAGI) must not exceed a limit set by the IRS on a yearly basis. For 2009 the limit for single individuals is $120,000 and for married couples, $176,000.
So while the Roth certainly has its advantages, it isn’t right for everyone. You have to make sure that the plan you choose is the right one for you. When in doubt, seek the advice of your CPA or other trusted financial advisor.
In Part II we’ll be taking a closer look at some of the other plans available to you, some with potential tax deductions of over $50,000. Check back in a few days for the next segment of our series “Back to School with Equity University.”
Filed under: About Equity Trust, Equity University, IRA Consultation, IRA Contributions, IRA Education, Managing Your IRA, Roth IRA, Traditional IRA, Uncategorized, self directed IRA on September 1st, 2009 | No Comments »
