IRA Financial’s Adam Bergman discusses the basics of the Individual Retirement Account (IRA) including the differences between the traditional and Roth plans and the benefits of saving with the plan.
In This Podcast
Mr. Bergman is going back to basics with this podcast. He discusses the different types of IRAs, including the traditional plan and the Roth option. Thanks to ERISA, the IRA plan was created back in the 1970s. As with other retirement plans, you must have earned income (such as salary from a job) to be able to contribute to an IRA. You may choose to contribute up to the annual limit or your income for the year, whichever is less. Additionally, if your spouse works and you don’t, he or she may contribute on your behalf with a Spousal IRA, essentially doubling the money you can put away each year. For 2020, you may contribute up to $6,000, plus an additional $1,000 if you are at least age 50.
There are essentially two types of IRA plans – traditional and Roth. The traditional IRA is more widely known and thus more popular. It is also known as the pretax IRA, in that there is an upfront tax break when you contribute to the plan. For example, if you earn $50,000 annually and contribute $5,000 to a pretax IRA, you will only owe taxes on $45,000 when they are due. Taxes are deferred until you start withdrawing during retirement.
Alternatively, there is the Roth IRA, or after-tax IRA. These plans are funded with after-tax money, meaning there is no immediate tax break. While traditional plans are funded with your income before taxes are paid, Roths are funded after taxes have been withdrawn. Therefore, they do not lower your tax bill. However, the main advantage is that all qualified distributions are tax free. Once the Roth has been opened for at least five years and you reach the age of 59 1/2, you never pay taxes on your distributions.
Another thing to consider is required minimum distributions, or RMDs. Once you reach the age of 72, you must start withdrawing funds from your traditional IRA, whether you need them or not. However, since taxes were already paid before contributing, Roth IRAs are not subject to the RMD requirements. This allows the plan funds to grow unhindered for as long as you want.
Lastly, in regards to the Roth IRA, there are income restrictions for directly contributing to the plan. Basically, if you make too much money, you cannot contribute to a Roth. However, there is a workaround, known as the Backdoor Roth IRA. With this, you can contribute after-tax funds to a traditional plan, and then convert them to a Roth. This allows high-earners to take advantage of the Roth IRA benefits.
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Join us next episode as Mr. Bergman discusses the prohibited transaction rules when it comes to investing with a self-directed retirement account.