Understanding Individual Retirement Arrangements (IRAs)

Dec 6

An IRA, or Individual Retirement Arrangement, is a type of retirement savings account that offers individuals tax advantages for the purpose of saving and investing for retirement. IRAs come in various forms, the most common being a Traditional IRA and a Roth IRA. Each type of IRA comes with its own set of rules regarding contributions, tax treatment, and distributions.

Contributions

A contribution is the amount of money you deposit into your IRA. There is an annual contribution limit that applies across all IRA accounts. For 2023 and 2024, these limits stand at $6,500 and $7,000, respectively. Individuals 50 and older have the option to contribute an additional $1,000 per year. Individuals can’t make contributions to a Traditional IRA after they turn 70 1/2. Roth IRAs do not have an upper age limit.

However, Roth IRAs do have income phase-out limits that may lower the contribution limit or disqualify individuals from contributing for the year. These limits vary based on filing status, with reduced or disallowed contributions at specified income thresholds. Individuals who are ineligible to contribute to a Roth IRA can still explore the option of contributing to a Traditional IRA if they are younger than 70 1/2 years old.

Tax Implications

Contributions to a Traditional IRA are typically tax-deductible in the year they are made. This means you can reduce your taxable income by the amount you contribute, providing an immediate tax benefit. When you withdraw funds from a Traditional IRA during retirement, the distributions are subject to income tax. The tax rate will be based on your tax bracket at the time of withdrawal.

Roth IRA contributions are made with after-tax dollars, meaning you don't get an immediate tax deduction for your contributions. One of the most significant advantages of a Roth IRA is that qualified withdrawals, including both contributions and earnings, are tax-free

Distributions

Withdrawals, also known as distributions, come with specific guidelines for each IRA type. For both Traditional and Roth IRAs, the age threshold for qualified distributions is 59 1/2. Early withdrawal results in a 10% penalty. However, since contributions to a Roth IRA are taxed upfront, an early withdrawal penalty will only apply to the earnings, not the initial contribution.

Required Minimum Distribution

With a traditional IRA, you must take required minimum distributions (RMDs) each year beginning the year you turn 72. RMDs are calculated by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy.

To determine your RMD, you can visit the IRS website to access their Required Minimum Distributions Worksheets.

Traditional IRA vs. Roth IRA Overview

  
    Traditional IRA
    Roth IRA
  
    Tax Deductible?
    Yes
    No
  
    Contribution Limit
    Up to $6,500 in 2023
    Up to $6,500 in 2023
  
    Contribution Limited by Income?
    No
    Yes, there are phaseout limits depending on filing status and income
  
    Age Limit for Contributions?
    Yes, can’t make regular contributions after 70 1/2 years old
    No
  
    Early Withdrawal Penalty
    Yes, 10% penalty for withdrawals before age 59 1/2
    No early withdrawal penalty on contributions, but there is a 10% penalty and tax on earnings before age 59 1/2
  
    Age Requirements for Withdrawals
    You must be at least 59 1/2 to withdraw and are required to start taking withdrawals when you reach age 72
    You must have held the account for at least five years and be at least 59 1/2 to withdraw from earnings
  
    Required Minimum Distribution?
    Yes
    No

	Traditional IRA	Roth IRA
Tax Deductible?	Yes	No
Contribution Limit	Up to $6,500 in 2023	Up to $6,500 in 2023
Contribution Limited by Income?	No	Yes, there are phaseout limits depending on filing status and income
Age Limit for Contributions?	Yes, can’t make regular contributions after 70 1/2 years old	No
Early Withdrawal Penalty	Yes, 10% penalty for withdrawals before age 59 1/2	No early withdrawal penalty on contributions, but there is a 10% penalty and tax on earnings before age 59 1/2
Age Requirements for Withdrawals	You must be at least 59 1/2 to withdraw and are required to start taking withdrawals when you reach age 72	You must have held the account for at least five years and be at least 59 1/2 to withdraw from earnings
Required Minimum Distribution?	Yes	No

Setting up an IRA

You can set up an IRA with various providers such as a bank, financial institution, life insurance company, mutual fund, or stockbroker. Once you open your account, you can start transferring funds and decide how to invest your money.

Which Type of Retirement Account is Best For Me?

There are a lot of factors that go into which type of retirement account may be better in your situation. Typically, a Traditional IRA is more beneficial for individuals closer to retirement age who can benefit from immediate tax deductions. A Roth IRA is well-suited for younger individuals who can invest their money for longer, allowing for tax-free growth over an extended period. However, it’s best to speak with a financial advisor so they can go over your situation with you.

At Northside Tax Service, we can’t help you determine which option is the best for your situation but we can help you understand the tax consequences of withdrawing from your retirement accounts. Learn more about our tax advising services: www.nstax.net/tax-advising

IRS Resources

Northside Tax Service