Traditional & Roth IRA are amongst the most popular self-funded investment options in USA after the 401k which is an employer provided plan. I have already written earlier about 401K (Understanding 401K Plans) and today, I am sharing my knowledge and learning about broad features of Traditional and Roth IRA.
Features of Traditional IRA
Contribution related features (for 2023):
- Age > 50: Upto $6,500 per annum
- Age > = 50: Upto $7,500 per annum
- Deductions vary according to your modified adjusted gross income (MAGI) and whether or not you’re covered by a retirement plan at work.
- You may be able to deduct some or all of your traditional IRA contributions. The deductible amount could be reduced or eliminated if you or your spouse is already covered by a retirement plan at work (spousal IRA provisions are given later in the article).
- Contribution deadline is April 15 of the following year.
- While you can contribute to an IRA for a spouse who isn’t working (as long as you file a joint tax return), the total contribution for both you and your spouse can’t exceed your joint taxable income or double the annual IRA limit, whichever is less.
- If you or your spouse is covered by a retirement plan at work, only a part of the corpus can be taxable.
Taxes on withdrawal from IRA
- Before 59½: 10% federal penalty tax plus regular income tax on the entire withdrawal.
- Between ages 59½ & 72: You can withdraw from a traditional IRA penalty-free for the most part. You’ll have to pay taxes on all principal contributions where deduction was claimed & any earnings.
- At age 72 & older: You will have to start taking your required minimum distribution (RMD) as soon as you reach age 73. The RMD amount is based on your life expectancy and the value of your account
When does penalty tax on withdrawal does not apply
Following are the qualifying exceptions to the penalty tax are as follows:
- Disability or death
- Distributed to a reservist who was ordered or called to active duty after September 11, 2001, for more than 179 days.
- A first-time home purchase (lifetime maximum: $10,000).
- Postsecondary education expenses.
- Substantially equal periodic payments taken under IRS guidelines.
- Certain unreimbursed medical expenses.
- An IRS levy on the IRA.
- Health insurance premiums (after you’ve received at least 12 consecutive weeks of unemployment compensation).
Spousal IRA provisions
There’s also something like a spousal IRA. Since one of the conditions for IRA contribution is that it should be out of earned income, a spousal IRA lets a nonworking spouse have access to the tax benefits that IRAs offer. It’s a separate single IRA set up in the spouse’s name and belonging exclusively to that spouse. But the condition to open this account is that you must be married and filing a joint tax return.
Features of Roth IRA
Contribution limits
- Age > 50: Upto $6,500 per annum
- Age > = 50: Upto $7,500 per annum
Note: This limit can get affected by the modified adjusted gross income (MAGI). However, good thing is that above limits do not apply for conversions e.g. from 401K to Roth IRA.
Taxation of contribution & withdrawals
- You cannot deduct contributions to a Roth IRA.
- If you satisfy the requirements, qualified distributions are tax-free.
- You can make contributions to your Roth IRA after you reach age 70 ½.
- You can leave amounts in your Roth IRA as long as you live.
- The account or annuity must be designated as a Roth IRA when it is set up.
Tax on withdrawal:
Withdrawals of principal contribution are both tax-free and penalty-free provided 5 year holding period is over (applies to every single contribution). However, withdrawal of earnings is a little complicated as follows:
- Before age 59½: For withdrawal of earnings, both taxes and penalties will apply irrespective of the holding period.
- After age 59½: You can withdraw your earnings from a Roth IRA penalty-free, provided your account has been open for at least 5 years.
Other features:
- Loans are not allowed
- No RMD (unlike traditional IRA) for as long as you live.
- If you’re planning to rollover your traditional IRA or 401K to Roth IRA, then it is treated as “income” in the year of rollover.
Also read: Vanguard link: Compare Roth vs. traditional IRAs
Copyright © CA Abhinav Gulechha. All Rights Reserved. No part of this article can be reproduced without prior written permission of the CA Abhinav Gulechha. The content of the article is for general information purposes only & does not constitute professional advice. My knowledge of US investments & tax laws is limited, Please consult a licensed CPA before taking any financial decision. For any feedback, please write to contact@abhinavgulechha.com