IRAs—individual retirement arrangements—are among the most popular retirement savings vehicles. They can be used to reduce taxes on retirement savings, but how do they work?
If you create a traditional IRA, you may be able to deduct some or all of your contributions to the account from your income taxes. You also may be eligible for a tax credit equal to a percentage of your contribution. Amounts in your traditional IRA, including earnings, generally aren’t taxed until they are distributed to you. Typically, this happens during retirement, when you may be in a lower income bracket. After your death, any funds remaining in your IRA will be paid to your beneficiaries.
IRAs aren’t just for office workers. You can fund one with taxable compensation—wages, salaries, commissions, tips, bonuses or net income—from self-employment. Certain alimony and maintenance payments, money received to aid in graduate or postdoctoral studies, or even certain difficulty-of-care payments may be treated as compensation that can be used to contribute to an IRA. There is no longer an age limit to contribute to an IRA (it used to be 70 1/2).
Distributions from a traditional IRA are fully or partially taxable in the year of distribution. Any money you take out before age 59 1/2 may be subject to an additional 10 percent tax. You also may owe an excise tax if you don’t begin to withdraw minimum distributions by April 1 of the year after the year you reach age 72 (this was raised from 70 1/2).
Roth IRAs — an important difference
A Roth IRA is the reverse of a traditional IRA in that contributions to such an account aren’t deductible and you don’t report the contributions on your tax return. However, you don’t pay taxes when you take distributions. To be a Roth IRA, an account must be designated as a Roth IRA when it’s set up. This type of account may be a good choice for someone who is in a low income bracket now but expects to be in a higher one later.
This is just an introduction to IRAs. There are other considerations as well, such as limits on how much you can contribute. If you have a work-related plan, such as a 401(k), that may also impact your IRA status. Be sure to work with R&A to ensure you are making the right decisions about your IRA management and retirement planning.
About this Author
Dave specializes in tax research, estates and trusts, complex partnerships, and corporate, not-for-profit, and private foundation tax compliance.