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Roth IRA or Traditional IRA

If you are thinking about opening your IRA, you may wonder if it's better for you to go with the Traditional or Roth IRA.
Both require that you earn at least as much income as the amount you contribute to an IRA. Both allow the same maximum annual contribution of $4000 for 2007, and $5000 for 2008. If you are age 50 or over, you may make an additional $1000 contribution annually to play "catch up". Both offer a tax-advantage over a non-IRA account. And both allow you to choose the exact investments you want for your IRA, allowing any income-earning individual to take responsibility for funding their own retirement.

To discourage people from using an IRA for things other than retirement, both types of IRAs may impose a 10% penalty for non-qualified distributions, that is, taking money out for reasons other than your retirement, or certain other qualified expenses. They both allow distributions, without incurring a penalty fee, for special circumstances, as long as the IRA has been open for five tax years. You may be allowed to withdraw funds from your IRA, without paying a penalty, for higher education costs, extreme medical expenses, long term unemployment that makes it necessary to pay your own medical insurance premium, disability, or due to a tax levy. You are also allowed to take out IRA money, without penalty, to use towards the purchase of your first home, with a lifetime limit of $10,000 per person.

Traditional IRA
This is the IRA we are all familiar with, the one that allows you to deduct the amount of your annual contribution on your income tax return. There are no income limits to use a traditional IRA, but you may be limited in how much you can deduct if you also qualify to use an employer's retirement plan, such as a 401(k) plan. Money in a traditional IRA will grow tax-deferred until you begin taking distributions at retirement, which can start at age 59 1/2, if you choose to. You are allowed to make traditional IRA contributions until the year you will reach age 70 1/2, which is the age that you must begin taking distributions.

The traditional IRA is good for those who could use a tax break now. If you know your income now is much higher than it will be at retirement, which is often the case for many, you may be better off delaying your tax bill until the day your tax rates are lower. Distributions from your traditional IRA will be taxed as regular income, at the tax rate of your income bracket at that time. Also, if your income is so high that you don't qualify for a Roth IRA, you have no choice but to open a traditional IRA.

Roth IRA
A Roth IRA is more flexible and has fewer restrictions regarding age; you can make contributions at any age, and you are never required to take distributions just because you reach a certain birthday. A Roth IRA can be used by an individual who earns less than $110,000 annually, or $160,000 for married couples who file a joint tax return. If you make more than that, you will have to go with the traditional IRA. Contributions to a Roth IRA are never tax-deductible, but all earnings will grow completely tax-free. A Roth IRA lets you get your income taxes over with now; you won't have to worry about taxes taking a cut out of your income when you're retired, and have better things to do with your money than pay a tax bill.

As long as the account has been opened for five or more years, you may begin to take qualified distributions at age 59 1/2, or you could leave the money in it as long as you want to. You are only restricted from withdrawal of the earnings in Roth IRA; the contributions may be withdrawn at any time without penalty or taxation, since you've already paid your taxes on that money. Of course, it's best to leave it there if at all possible so it can continue to grow, but it's nice to know it's there if you really need it.

The Roth IRA was designed to help middle and lower income taxpayers who do not make enough money to benefit from the tax deduction that a traditional IRA offers, and its benefits far outweigh those of the traditional IRA. If you qualify for a Roth IRA, consider taking full advantage of this wonderful plan. The positive effect of a Roth IRA's tax-free growth is more substantial for those who are still quite young, and even more so if you maximize your contributions each year.

Where You Can Open Your IRA
The Young Person's Guide to Financial Independence


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Sunday, 10 December 2023

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