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Individual Retirement Account (IRA)

Updated: Feb 20

An Individual Retirement Account (IRA) is a type of investment account designed to help individuals save for retirement in a tax-advantaged manner. IRAs are offered by financial institutions such as banks, brokerage firms, and mutual fund companies.

There are two main types of IRAs: Traditional IRA and Roth IRA. The primary differences between them lie in how they are taxed, when taxes are paid, and the rules governing contributions and withdrawals.

Traditional IRA:

  • Tax Treatment: Contributions to a Traditional IRA are often tax-deductible, meaning you can deduct the amount you contribute from your taxable income for the year in which you make the contribution. This can result in immediate tax savings. Taxation upon Withdrawal: Funds in a Traditional IRA grow tax-deferred, meaning you don't pay taxes on the earnings until you withdraw the money. Withdrawals in retirement are subject to ordinary income tax rates. Eligibility for Contributions: Anyone with earned income can contribute to a Traditional IRA, regardless of income level. However, the ability to deduct contributions may be limited based on income and whether you or your spouse are covered by an employer-sponsored retirement plan.

Roth IRA:

  • Tax Treatment: Contributions to a Roth IRA are made with after-tax dollars, so there is no immediate tax deduction. However, qualified withdrawals, including earnings, are tax-free in retirement. Taxation upon Withdrawal: Contributions to a Roth IRA can be withdrawn at any time tax-free since taxes were already paid on that money. Earnings can be withdrawn tax-free after age 59½ and if the account has been open for at least five years. Eligibility for Contributions: Roth IRAs have income limits for contributions. Eligibility to contribute to a Roth IRA is phased out for higher-income earners.

Rules and Penalties:

  • Early Withdrawal Penalty: Withdrawals from either type of IRA before age 59½ may incur a 10% early withdrawal penalty, in addition to regular income taxes, unless an exception applies (such as certain medical expenses or first-time homebuyer expenses). Required Minimum Distributions (RMDs): Traditional IRAs require you to start taking required minimum distributions (RMDs) by age 73 (previously 70½). Roth IRAs do not have RMDs during the lifetime of the original account holder. Annual Contribution Limits: As of 2024, the annual contribution limit for both Traditional and Roth IRAs is $7,000 for individuals under age 50 and $8,000 for those aged 50 and older (including catch-up contributions).

It's important to note that tax laws and contribution limits can change, so it's advisable to consult with a financial advisor or tax professional for the most up-to-date information and guidance on retirement planning strategies.

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