Congress passed the Employee Retirement Income Security Act in 1974, which included provisions for the first individual retirement accounts, commonly known as IRAs. These tax-advantaged accounts were originally only available to self-employed taxpayers and workers who were not covered by a qualified retirement plan at work. Subsequent legislation has expanded the eligibility for IRAs to most taxpayers who have earned income. With the advent of Roth IRAs, taxpayers also have a choice of whether to make their contributions on a pretax or after-tax basis.
There are two primary types of individual retirement accounts: traditional IRAs and Roth IRAs. Both offer specific tax advantages, but those advantages are significantly different. You fund a traditional IRA with pretax dollars, while you use after-tax dollars to fund your Roth IRA. Contributions and any earnings they produce are allowed to grow without incurring a tax obligation as long as they remain in the IRA account. Qualified withdrawals from a traditional IRA are taxed as ordinary income, while qualified withdrawals from a Roth IRA are free from federal income taxes.
There is no minimum age for making contributions to either a traditional or Roth IRA. You can make contributions in any tax year that you have earned income. There is no upper age limit for making contributions to a Roth, but you may not make contributions to your traditional IRA once you reach 70 1/2 years of age. There is no requirement for you to take any mandatory withdrawal from your Roth IRA, but you must begin taking mandatory withdrawals from your traditional IRA once you reach 70 1/2 years of age.
You can start taking qualified withdrawals from your traditional IRA once you reach 59 1/2 years of age. Any qualified withdrawals you make from your traditional IRA will be taxed as ordinary income at your then current tax rate. You can withdraw any amounts you contributed to a Roth IRA at any time without paying federal income taxes, because you have already paid taxes on those funds. You can make tax-free withdrawals of the earnings generated by contributions to your Roth IRA once you reach 59 1/2 years of age, provided the earnings have remained in your Roth IRA for at least five years.
Non-qualified withdrawals from either a traditional or Roth IRA will be taxed as ordinary income at your tax rate in the year they are received. You will also be charged an additional penalty of 10 percent of the non-qualified amount withdrawn. You may be able to avoid the tax penalty if your withdrawal is for certain hardship reasons as determined by the Internal Revenue Service.
You may be better off contributing to a traditional IRA if you are in a high tax bracket and expect to be in a significantly lower tax bracket when you begin to withdraw your funds. This is because you will pay income taxes on these funds at the lower rate. If you expect to be in a higher tax bracket when you begin withdrawing funds from your retirement account, you may be better off paying current income taxes and avoiding the higher tax bite later on.
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