The U.S. Congress authorized the first individual retirement accounts in 1974. The two primary benefits of contributing to a traditional IRA were tax-deferred earnings and the ability to deduct your contributions from your income when you filed your federal income tax return. Congress later authorized the Roth IRA, which has some similarities to the traditional IRA, but also some significant differences, particularly when it comes to the tax deductibility of contributions.
Adjusted Gross Income
Your gross income includes all income you receive from all sources including employee compensation such as wages, salaries, tips and commissions, self-employment income, unearned income such as dividends and interest, business and partnership income and bartered income. The Internal Revenue Service considers all income to be taxable income unless it is specifically exempted from taxation by tax law. There are numerous adjustments to your income that are allowed by law, including certain educator expenses, certain moving expenses, certain expenses for tuition and fees, and contributions to a traditional IRA. Your gross income minus all adjustments to your income equals your adjusted gross income, commonly referred to as your AGI.
Roth IRAs are tax-advantaged retirement accounts that share some similarities with traditional IRAs, but also feature significant differences. All growth of assets within a Roth IRA is treated the same, regardless of how the growth occurs. Interest payments, dividend payments and capital gains are treated identically. The taxes on all growth in a Roth IRA are deferred until they are withdrawn.
You can only make contributions to your Roth IRA with cash or cash equivalents, such as a check or money order. You cannot contribution merchandise, property or securities such as stock or shares of a mutual fund into your Roth IRA, although you may use the funds in your IRA to purchase such securities. Unlike contributions to a traditional IRA, which are tax deductible as an adjustment to your income, your contributions to a Roth IRA must be made with after-tax dollars. Your contributions to your Roth IRA do not affect your adjusted gross income (AGI).
Qualified withdrawals from a traditional IRA must be reported to the Internal Revenue Service and are taxed as ordinary income, but qualified withdrawals from a Roth IRA are free from federal income taxes and do not need to be reported. You can withdraw an amount equal to your contributions from your Roth IRA at any time and for any reason without causing a taxable event, since you have already paid taxes on these funds. All earnings produced in your Roth IRA must remain in the account for at least five years to qualify for tax-free withdrawal. You may begin taking qualified withdrawals from your Roth IRA once you reach age 59 1/2 years of age. If you take withdrawals of the earnings portion of your Roth IRA prior to reaching 59 1/2 years or before the earnings have been in the account for at least five years, you will have to include the amount withdrawn as ordinary income. You will pay taxes on the non-qualified withdrawal and you will be subject to a 10 percent tax penalty.
Withdrawals and AGI
Qualified withdrawals from your Roth IRA are not reported as income and do not affect your AGI. Withdrawals of amounts equal to your Roth IRA contributions are not reported as income and do not affect your AGI. Non-qualified withdrawals from your Roth IRA must be reported as ordinary income, and these withdrawals will increase your AGI.
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