Saving for retirement is an important part of financial planning. Being familiar with the rules of both the Roth and Traditional IRA is important. It might seem complicated at first, but it’s really not. You don’t have to have it memorized, just be familiar with it.
The main difference between a Roth IRA and a Traditional IRA is taxes. Basically, in a Roth you pay taxes now, in a Traditional you pay taxes later. The general thinking is that over time you will earn more, therefore you will be in a higher tax bracket, so it’s better to pay the taxes now. Plus, tax rates don’t tend to go down over time, right?. But not everyone qualifies, and every situation is different, so research both plans.
Today we are talking about Traditional IRAs.
Traditional IRAs are funded by before tax dollars. This means that you do not have to pay income taxes on the amount of money you put into your Traditional IRA. If you put money into your Traditional IRA from your net income, then you will receive a refund on the taxes you paid on your contributions when you file your tax return.
Any earnings in the Traditional IRA are tax deferred. This means that you don’t have to pay taxes on the the money you make until you withdraw it.
The bottom line: All of the money inside your Traditional IRA has never been taxed. You will owe income taxes on all withdrawals.
You can contribute up to $5,000 per year into your Traditional IRA. These contributions must be made with earned income. This means money from a job. Passive income, such as stock dividends, cannot be used to fund Traditional IRAs. If you are over 50 years old you can contribute an additional $1,000 (for a total of $6,000) as a ‘catch-up’ contribution. You must be under 70.5 years old at the end of the tax year in order to contribute.
The bottom line: From the time you start working until you turn 50 you can contribute $5,000. Between 50 and 70.5 you can contribute $6,000. After 70.5 you can’t contribute.
To be allowed to contribute the full $5,000 you have to make under a certain amount of money. These income limits depend on whether or not you participate in an employer sponsored plan. If you participate in a retirement plan at work and file as single or head of household you must make under $56,000 to be able to contribute the full $5,000. If you make between $56,000 and $66,000 then your contributions are phased-out. You can contribute some to a Traditional IRA, but not the full $5,000. The closer you get to earning $66,000 the less you can contribute. If you make over $66,000 you can’t contribute at all.
If you participate in a retirement plan at work and you file as married filing jointly then you must make under $90,000 to contribute the full $5,000. If you make between $90,000 and $110,000 then your contributions are phased out, you can contribute some, but not the full amount. The closer you get to earning $110,000 the less you can contribute. If you make over $110,000 you can’t contribute at all.
If neither you or your spouse participate in a retirement plan at work then there are no income limits to participate in a Traditional IRA. If your spouse is covered then you must make less than $169,000 to contribute the full amount. If you make more than $169,000 but less than $179,000 then your contributions are phased out. The closer you get to earning $179,000 the less you can contribute. If you earn over $179,000 then you can’t contribute at all.
The bottom line(s): If you are single, participate in a retirement plan at work, and make less than $56,000 you can make a full contribution. If you make more than $66,000 you can’t contribute.
If you are married, participate in a retirement at work, and make less than $90,000 you can contribute the full amount. If you earn more than $110,000 you can’t contribute.
If neither you nor your spouse participates in a retirement plan at work there are no income limits.
If you don’t participate in a work plan but your spouse does and you make less than $169,000 you can make a full contribution. If you make more than $179,000 you can’t contribute.
The government doesn’t like being lied to. If you tell them you are going to use the money in retirement and then don’t you have to pay a price. In a Traditional IRA that price is 10%. There are plenty of if, ands, and butts which are beyond the scope of this article.
The Bottom Line: If you take money out of your Traditional IRA before 59.5 you will owe income taxes and a 10% penalty.