An Overview and Choice of Ira for You: Traditional, Non-Deductible or Roth
By Shane Flait © 2008

Individual Retirement Accounts (IRAs) were created to help you save for your retirement. They’re qualified/IRA regulated tax shelters. Let’s take a look at them and their characteristics.

Versions and their taxation:
IRAs come in 3 versions:

·         deductible IRA (often called traditional),

·         nondeductible IRA, and

·         Roth IRA.

One characteristic common to all is that your investment in them grows tax deferred. But in the Roth IRA, the money grows tax free and remains tax free even as you withdraw it from the Roth account. That’s because you can only put money that has already been taxed into it. However, there’s no initial tax break – i.e. a tax deduction – for contributing money into a Roth IRA.

Deductible IRAs are so named because the money you contribute to them is deductible from your income in the year you contribute. That’s the first tax break. The second is that this money will grow tax-deferred. But when you withdraw money from the account, it’ll be fully taxable as ordinary income.

The non-deductible IRA allows only after (income) tax contributions. The money will still grow tax deferred, but only the earnings on it will be taxed when it comes out. The amount you contributed, called your basis in the account, will come out tax free since you paid tax on it before it putting it in.

How much can you contribute to these IRAs?
Your contributions are restricted to annual limits - $5000 in 2008. If you’re at least 50 by the end of the year, you can contribute an extra $1000. This limit applies as the total contribution you can make among all your IRAs – if you have more than one.

Who gets to contribute to the IRAs?
Only if your employer has a retirement plan can your eligibility to contribute be restricted. If you do have an employer plan, your tax-deductible annual contribution (to a traditional IRA) is phased to zero between certain income limits depending on whether you’re single or married. Refer to the table[1] below which nicely summarizes all the rules. You can contribute to the non-deductible IRA, though.

You can contribute to a Roth IRA but only if you’re income is below certain income limits (see table below).

You must have working income at least as great as your contribution to contribute to an IRA. This is not necessary if you’re contributing to a spousal IRA.

What about taking money out?
Generally you’re penalized an amount equal to 10% of what you withdraw if you take out money before turning 59½ in addition to paying income tax on it too.  There are some exceptions to the 10% penalty part such as if you’re disabled or take money out in substantially equal amounts for ever, or for a down payment on a house – see other rules[2]

Unlike the Roth IRA, you must begin withdrawing a minimum required distribution[3] (MRD) from the other two IRAs the year after you turn 70 ½.  This is geared for you to use up most of these IRAs while you live if you live long enough.

Roth IRAs represent a place for storing tax free money that grows tax free. That’s a true savings plan!  What’s also true is you can roll over 401(k)s and traditional IRAs into a Roth IRA.

IRA type	Who's eligible to contribute in 2008	Annual contribution for 2008	Withdrawals
Deductible IRA (traditional)	If spouses employers have a employer-sponsored retirement plan then eligibility phases out: For  individuals with modified adjusted gross income (MAGI) between $53,001 and $63,000 and for married couples between $85,001 and $105,000.   If only one spouse participates in an employer-sponsored plan, deductible IRA eligibility phases out: between MAGI of $159,001 and $169,000 for uncovered spouse, between $85,001 and $105,000 for covered spouse   If single or either of married couple can't participate in plan: No income restriction to IRA contribution.	$5,000 ($6,000 if you are age 50 or older at year-end).	Withdrawals: are taxed as ordinary income. Penalty-free withdrawals permitted before age 59 1/2 for first-time home purchase up to $10,000, higher education expenses or in event of disability or death.   Must begin at 70 ½ with a minimum required to be withdrawn
Nondeductible IRA	Everyone who has earned income.	As above	As above
Roth IRA	Eligibility phases out between MAGI of $101,000 and $116,000 for singles, and $159,000 and $169,000 for married couples. And for married filing separately, $0 and $10,000.	As above	Withdrawals: Are Tax-free and penalty-free after five years if you are 59 1/2 or in the following circumstances: death, disability or for first-time home purchase up to $10,000. Penalty-free, but not tax-free withdrawals permitted before age 59 1/2 for higher education expenses.   No minimum withdrawal at any age

Passing it on
Lastly, you can assign a beneficiary to your IRA account. In the case of your death, the account will pass automatically to your beneficiary – and therefore, outside of probate. The rules for taxation and distribution will depend on who the beneficiary is – spouse, nonspouse, other entity.

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com