| | All About IRAs
An individual retirement arrangement (IRA) is a personal
retirement savings plan that offers specific tax benefits. In fact, IRAs are
one of the most powerful retirement savings tools available to you. Even if
you're contributing to a 401(k) or other plan at work, you might also consider
investing in an IRA.
What types of IRAs are available?
There are two major types of IRAs: traditional IRAs and Roth
IRAs. Both allow you to make annual combined contributions of up to $6,500 in 2023 (up from $6,000 in 2022). Generally, you must have at least as much taxable compensation as the
amount of your IRA contribution. But if you are married filing jointly, your
spouse can also contribute to an IRA, even if he or she does not have taxable
compensation. The law also allows taxpayers age 50 and older to make additional
"catch-up" contributions. These folks can put up to an additional $1,000 in their IRAs in 2023.
Both traditional and Roth IRAs feature tax-sheltered growth
of earnings. And both typically offer a wide range of investment choices. However,
there are important differences between these two types of IRAs. You must
understand these differences before you can choose the type of IRA that may be appropriate
for your needs.
Traditional IRAs
Practically anyone can open and contribute to a traditional
IRA. The only requirement is that you must have taxable compensation. You can contribute the maximum allowed each year as long as your
taxable compensation for the year is at least that amount. If your taxable
compensation for the year is below the maximum contribution allowed, you can
contribute only up to the amount you earned.
Your contributions to a traditional IRA may be tax
deductible on your federal income tax return. This is important because
tax-deductible (pre-tax) contributions lower your taxable income for the year,
saving you money in taxes. If neither you nor your spouse is covered by a
401(k) or other employer-sponsored plan, you can generally deduct the full
amount of your annual IRA contribution. If one of you is covered by such a plan,
your ability to deduct your contributions depends on your annual income
(modified adjusted gross income, or MAGI) and your income tax filing status.
You may qualify for a full deduction, a partial deduction, or no deduction at
all.
Traditional IRAs - Tax Year 2023Individuals Covered by an Employer Plan |
---|
Filing status | Deduction is limited if MAGI
is between: | No deduction if MAGI
is equal to or more than: |
---|
Single/Head of
household | $73,000 and $83,000 | $83,000 |
---|
Married joint* | $116,000 and $136,000 | $136,000 |
---|
Married separate | $0 and $10,000 | $10,000 |
---|
* If you're not covered by an employer plan but
your spouse is, your deduction is limited if your MAGI is between $218,000 and $228,000,
and eliminated if your MAGI is $228,000 or more. |
---|
What happens when you start taking money from your
traditional IRA? Any portion of a distribution that represents deductible
contributions is subject to income tax because those contributions were not
taxed when you made them. Any portion that represents investment earnings is
also subject to income tax because those earnings were not previously taxed
either. Only the portion that represents nondeductible, after-tax contributions
(if any) is not subject to income tax. In addition to income tax, you may have
to pay a 10% early-withdrawal penalty if you're under age 59½, unless you meet
one of the exceptions.
For details on these exceptions, please visit the IRS website. If you wish to defer taxes, you can leave your funds in the
traditional IRA, but only until April 1 of the year following the year you
reach age 73 (for those who reach age 72 after December 31, 2022). That's when you have to take your first required minimum
distribution (RMD) from the IRA. After that, you must take a distribution by the end
of every calendar year until your funds are exhausted or you die. The annual
distribution amounts are based on a standard life expectancy table. You can
always withdraw more than you're required to in any year. However, if you
withdraw less, you'll be hit with a 25% penalty on the difference between the
required minimum and the amount you actually withdrew. (The penalty may be further reduced to 10% if you self-correct the error by withdrawing the shortfall amount and filing a return within a specific correction window.) Roth IRAs
Not everyone can set up a Roth IRA. Even if you can, you may
not qualify to take full advantage of it. The first requirement is that you
must have taxable compensation. If your taxable compensation is at least $6,500
in 2023, you may be able to contribute the full amount. But it gets
more complicated. Your ability to contribute to a Roth IRA in any year depends
on your MAGI and your income tax filing status. Your allowable contribution may
be less than the maximum possible, or nothing at all.
Roth IRAs — Tax Year 2023Filing status | Contribution is limited if MAGI
is between: | No contribution if
MAGI is over: |
---|
Single/Head of
household | $138,000 - $153,000 | $153,000 |
---|
Married joint | $218,000 - $228,000 | $228,000 |
---|
Married separate | $0 - $10,000 | $10,000 |
---|
Your contributions to a Roth IRA are not tax deductible. You
can invest only after-tax dollars in a Roth IRA. The good news is that if you
meet certain conditions, your withdrawals from a Roth IRA will be completely
free of federal income tax, including both contributions and investment
earnings. To be eligible for these qualifying distributions, you must meet a
five-year holding period requirement. In addition, one of the following must
apply:
- You have reached age 59½ by the time of the withdrawal
- The withdrawal is made because of disability
- The withdrawal is made to pay first-time homebuyer
expenses ($10,000 lifetime limit from all IRAs)
- The withdrawal is made by your beneficiary or estate
after your death
Qualified distributions will also avoid the 10% early
withdrawal penalty. This ability to withdraw your funds with no taxes or
penalty is a key strength of the Roth IRA. And remember, even nonqualified
distributions will be taxed (and possibly penalized) only on the investment
earnings portion of the distribution, and then only to the extent that your
distribution exceeds the total amount of all contributions that you have made.
Another advantage of the Roth IRA is that there are no
required distributions during your life. You can
put off taking distributions until you really need the income. Or, you can
leave the entire balance to your beneficiary without ever taking a single
distribution. Making the choiceAssuming you qualify to use both, which type of IRA might be appropriate
for your needs? The Roth IRA might be a more
effective tool if you don't qualify for tax-deductible contributions to a
traditional IRA or if you want to help reduce taxes during retirement and preserve assets for
your beneficiaries. But a traditional deductible IRA may be a better tool if
you want to lower your yearly tax bill while you're still working and possibly
in a higher tax bracket than you'll be in during retirement. Note:
You can have both a traditional IRA and a
Roth IRA, but your total annual contribution to all of the IRAs that you own
cannot exceed the annual contribution limit. |