Traditional IRA
From Wikipedia, the free encyclopedia
A traditional IRA is an individual retirement account (IRA) in the United States. The IRA is held at a custodian such as a bank or brokerage, and may be invested in anything that the custodian allows (for instance, a bank may allow certificates of deposit, and a brokerage may allow stocks and mutual funds). Unlike the Roth IRA, the only criterion for being eligible to contribute to a Traditional IRA is sufficient income to make the contribution. However, the best provision of a Traditional IRA — the tax-deductibility of contributions — has strict eligibility requirements based on income, filing status, and availability of other retirement plans (mandated by the Internal Revenue Service). Transactions in the account, including interest, dividends, and capital gains, are not subject to tax while still in the account, but upon withdrawal from the account, withdrawals are subject to federal income tax (see below for details). This is in contrast to a Roth IRA, in which contributions are never tax-deductible, but qualified withdrawals are tax free. The traditional IRA also has more restrictions on withdrawals than a Roth IRA. With both types of IRA, transactions inside the account (including capital gains, dividends, and interest) incur no tax liability. Here is a 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s.
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Traditional IRA contributions are limited as follows:
| Year | Age 49 and Below | Age 50 and Above |
|---|---|---|
| 2005 | $4,000 | $4,500 |
| 2006–2007 | $4,000 | $5,000 |
| 2008 | $5,000 | $6,000 |
[edit] Advantages
- The main advantage of a Traditional IRA, compared to a Roth IRA, is that contributions are often tax-deductible. If a taxpayer contributes $4,000 to a traditional IRA and is in the twenty-five percent marginal tax bracket, then a $1,000 benefit ($1,000 reduced tax liability) will be realized for the year. Because qualified distributions are taxed as ordinary income (the taxpayer's highest rate), the long-term benefits of the traditional IRA are only comparable to those of a Roth IRA (whose qualified distributions are tax free) if the current year tax benefit ($1,000 above) is reinvested.
- Also, if a taxpayer expects to be in a lower tax bracket in retirement than during the working years, then a traditional IRA offers an increased incentive over the Roth IRA.
- Another advantage of a Traditional IRA is that the taxpayer gets the tax benefit immediately.
- With the Roth IRA, there may be a risk that over the next several decades Congress will decide to tax Roth IRA distributions.
[edit] Disadvantages
- There are the eligibility requirements for the tax-deductibility. If one is eligible for a retirement plan at work, one's income must be below a specific threshold for your filing status.
- All withdrawals from a Traditional IRA are included in gross income and subject to federal income tax (with the exception of any nondeductible contributions; there is a formula for determining how much of a withdrawal is not subject to tax). If one's investment style is buy-and hold or dividend-seeking, then a Traditional IRA is at a disadvantage since holding stocks in an IRA means they lose their favorable tax treatment given to dividends and capital gains.
- If one has a lot of disposable income, a Roth IRA in effect shelters more assets from taxes on gains than a Traditional IRA does. Suppose someone with $4000 to invest is eligible to either contribute $4000 to a Roth IRA, or to contribute $4000 to a Traditional IRA and deduct it. If one chooses the Traditional IRA, then one receives an upfront tax deduction (worth, say, $1000 to someone in the 25% tax bracket), but that money is not tax-sheltered and must be invested in a taxable account, where certain types of gains cause taxes to be levied. When the money is withdrawn from the Traditional IRA it will be taxed at marginal rates. On the other hand, if one chooses the Roth IRA, then there is no upfront tax deduction, but the money and the gains are all exempt from taxes upon retirement. So someone with much disposable income must generally be certain to be in a lower tax bracket upon retirement for a Traditional IRA to be preferred to a Roth IRA.
- Perhaps the greatest disadvantage of the Traditional IRA is its forced distributions based on age. Withdrawals must begin at age 70½ (more precisely, April 1 of the calendar year after age 70½ is reached) according to a complicated formula. If an investor fails to make the required withdrawl, half of the mandatory amount will be confiscated automatically by the IRS. The Roth is completely free of these mandates.
- In addition to the distribution being included as taxable income, the IRS will also assess a 10% early distribution penalty if the participant is under age 59½. The IRS will waive this penalty with some exceptions, including first time home purchase, higher education expenses, death, disability, unreimbursed medical expenses, health insurance, annuity payments and payments of IRS levies, all of which must meet certain stipulations.
[edit] Income limits
If a taxpayer's household is covered by one or more employer-sponsored retirement plans, then the deductibility of traditional IRA contributions are phased out as specified income levels are reached.
- Married Filing Jointly or Qualified Widow and Modified Adjusted Gross Income is between $75,000 and $85,000 (this is scheduled to rise to $80,000 to $100,000 in 2007)
- Married Filing Separately (and you lived with your spouse at any time during the year) and modified AGI is between $0 and $10,000
- Single, Head of Household or Married Filing Separately (and you did not live with your spouse) and modified AGI is between $50,000 and $60,000
The lower number represents the point at which the taxpayer is still allowed to deduct the entire maximum yearly contribution. The upper number is the point as of which the taxpayer is no longer allowed to deduct at all. The deduction is reduced proportionally for taxpayers in the range. Note that people who are married and lived together, but who file separately, are only allowed to deduct a relatively small amount.
[edit] Converting a Traditional IRA to a Roth IRA
Conversion of a Traditional IRA to a Roth IRA results in the converted funds becoming taxed in the year they are converted (with the exception of non-deductible assets).
Two circumstances prohibit a conversion to a Roth IRA: Modified Adjusted Gross Income exceeding $100,000 or the participant's tax filing status is Married Filing Separately.
[edit] Transfers vs. Rollovers
Transfers and rollovers are two ways of moving IRA sheltered assets between financial institutions.
A transfer is normally initiated by the institution receiving the funds. A request is sent to the disbursing institution for a transfer and a check (made payable to the other institution) is sent in return. This transaction is not reported to the IRS
A rollover (sometimes referred to as a 60 day rollover) can also be used to move IRA money between institutions. A distribution is made from the institution disbursing the funds. A check would be made payable directly to the participant. The participant would then have make a rollover contribution to the receiving financial institution within 60 days in order for the funds to retain their IRA status. This type of transaction can only be done once every 12 months with the same funds. Contrary to a transfer, a rollover is reported to the IRS.
[edit] "Borrowing Money" From an IRA
A loan from an IRA is prohibited. It is considered a prohibited transaction and the IRS may disqualify your plan and tax you on the assets. Some use the 60 day rollover as a way to temporarily take funds from an IRA. A participant will take a distribution and, in turn, all or some of the distribution that the participant takes may be rolled back into the same IRA plan within the allowed period to retain its tax deferred status.
[edit] External links
- Individual Retirement Accounts at the Open Directory Project (suggest site)
- IRA Publication 590 (IRAs) (pdf)
- Which IRA Is Right for You: Roth or Traditional?
