Three Types of IRAs
By: Source: AARP.org Date Posted: 2005-03-20 12:09:07
When you open an IRA, you'll have to decide whether to open a Traditional IRA, a Roth IRA, or an Education IRA. Each has its own rules and tax advantages.
What You Should Know
Traditional IRA
Congress created the Traditional IRA in 1974. You won't pay taxes on the money you earn from this IRA until you start withdrawing the money from that account in retirement. You may also be able to deduct your annual IRA contributions from your taxable income each year. This will depend on how much money you earn.
The Traditional IRA has several rules governing contributions and withdrawals:
- You can't begin withdrawing money from your IRA until you reach 59½. If you must withdraw money before that time, you'll pay a tax penalty.
- You must start withdrawing money from your IRA when you turn 70½. You'll pay income taxes on any money you withdraw. You'll probably want to spread out your withdrawals over several years. That way, you won't get stuck with a burdensome tax bill in any one year.
- If you fail to make withdrawals on schedule, or don't withdraw enough money, you will pay a penalty.
- You can't contribute any more money to your IRA after you reach age 70½.
Roth IRA
The Roth IRA was established in 1997. Only individuals with certain incomes can open a Roth IRA. With this IRA, you will never pay taxes on the income you earn through your IRA investments, as long as your withdrawals comply with IRS rules. This means that your earnings from a Roth IRA grow tax-free over many years. In addition, these rules apply:
- You can't deduct your annual Roth contributions from your taxable income.
- You can't start using your Roth earnings until you turn 59½.
- You don't have to withdraw money from the account, or pay additional taxes, when you turn 70½.
- You can keep contributing money to the IRA for as long as you have earned income.
Education IRA
You can use an Education IRA to save for a child or grandchild's education. Until now, you could only contribute $500 in after-tax money to an Education IRA each year. This limit changes in 2002. After that, you can contribute $2,000 a year to an Education IRA. Interest, dividends, and capital gains earned from these accounts can be withdrawn tax free to pay tuition for private and parochial schools from kindergarten through college. You can only contribute to an Education IRA if you meet IRS income limits.
Traditional or Roth?
If you're using an IRA to save for retirement, you must choose between the Traditional IRA and the Roth IRA. At face value, it may seem that the Roth IRA, with its tax-free investment growth and flexible withdrawal policies, is the better deal for a retirement saver. For some investors, this may be true. But whether a Roth is best for you will depend on your own financial situation, including your tax bracket, your other income sources, and your other investments. To be sure, check with a tax specialist.
Parting Advice
Remember that you choose where your IRA funds will be invested. The investments you make won't be any safer or more lucrative because they are part of an IRA account. You can lose money inside an IRA just as easily as you can lose it outside an IRA. Research your investments thoroughly and invest with care.
For More Information
Qualifying for an IRA
Anyone, regardless of his or her income, can contribute to a Traditional IRA. However, only investors with certain incomes can deduct their Traditional IRA contributions from their taxable incomes each year. Likewise, your income will determine how much you can contribute each year to a Roth IRA.
It's best to go to the source to find out how the Internal Revenue Service (IRS) regulations affect your ability to save through a Traditional or Roth IRA. Read IRS Publication 590: Individual Retirement Arrangements. You can order the publication by calling 800-829-3676 or you can read it online at the IRS Web site.
URL: http://www.irs.gov
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