by Jose L. Fugencio
A few days ago I was speaking to my father, that I am contemplating retirement in two years. My dad laughed and said, “Good luck with that one.” I know I was being sarcastic but retirement planning should not wait and I have to consider options, like an IRA and Roth IRA.
You may be asking, “WTF is an IRA?” No worries, let me explain. Pay attention because there are some tax-free benefits you may not know about!
IRA – Individual Retirement Account
IRA stands for individual retirement account and there are two popular ones, IRA and Roth IRA. IRA’s and Roth IRA’s are accounts you set-up with a financial institution.
There are difference between an IRA and a Roth IRA that you should know about before opening either account:
- Tax Incentives – What is the impact to taxes?
- Qualifications – Who can contribute?
- Contributions – How much can I contribute?
- Withdrawal Rules – Are there restrictions to withdrawing money?
Why is an IRA better than a regular savings or investment account?
The main reason to open an IRA or Roth IRA account is it allows for tax-free growth unavailable in a regular savings or stock investment account.
Tax-free growth: In a traditional savings account or stock investment account, you get taxed at the end of the year for any interest or dividends earned. IRA and Roth IRA accounts are TAX-FREE growth! You will not be taxed as the value of the account grows due to interest or dividend payments. Not paying taxes while the account is growing allows you to grow more money faster.
Tax-deferred basis: Means you defer (delay) paying taxes. You will be taxed when you withdraw funds from your IRA.
However, unlike a savings or investment account, you have limits on how much you can deposit into your IRA account every year. From the latest 2015-2016 tax information, you can contribute up to $5,500 per year, but for those 50 or older the limit is $6,500. Since there are great tax savings benefits, it is important to try to contribute as much as possible every year.
IRA, in addition to being tax-free growth also allows you to defer paying taxes on contributions (deposits made into an IRA). The contributions made can be deducted from your tax return so you do not pay any taxes on money deposited into your IRA. You will pay the taxes later on in life, when you withdraw the money. Retirees who will be in lower tax brackets when they retire will benefit from paying lower tax rates.
The disadvantages of an IRA is that you cannot pass the account onto your heirs in a will but can inherit an IRA if you are a beneficiary. Then you would have to start withdrawing the money by the age of 70½. If you withdraw before the age of 59½ there is a 10% early withdrawal penalty.
The Roth IRA
Roth IRA has two differences in taxes and benefits. In a Roth IRA you can leave the money to heirs and you do not pay taxes when you withdraw money! Roth IRAs still benefit from tax-free growth but any contributions (money deposited) are not eligible for a tax deduction in your tax return.
Roth IRAs exist to allow people with moderate to lower incomes to save for retirement and never have to worry about paying taxes on the money withdrawn when they retire. You can only contribute to a Roth IRA if you earn less than $117,000 a year if you are single and $184,000 a year combined household income if you are married.
Before opening an IRA account consider your best options and review the Best IRA Accounts for 2016.
Jose L. Fulgencio is an educator, blogger, podcaster, founder of #Save4You twitter chat, and startup founder of LDMS Media, a technology integration company. As an educator, Jose enjoys teaching others ways to succeed in their life goals, personal finances, and finding solutions to integrate technology in their classroom. Follow on Twitter @joseful