By Standard & Poor's
Investors have two options for their individual retirement accounts (IRAs). The first option is a traditional IRA, the second option is a Roth IRA (named for the account's congressional sponsor), which features -- among other benefits - the ability to accumulate tax-free earnings under certain circumstances. In this report we'll discuss the features of the traditional IRA. You may want to review material outlining the Roth IRA - or talk to your financial planner - before you make a decision as to which IRA is right for you.
What Is a Traditional IRA?
An individual retirement account allows your investment earnings to grow tax deferred until withdrawn, typically at retirement. Generally, if you have earned income or receive alimony, you can establish as many IRA accounts as you want prior to the tax year in which you reach age 70 1/2. You may also have an IRA even if you participate in a qualified pension, profit-sharing, or other retirement plan. Your entire contribution may not be deductible on your income tax return, depending on your income and your eligibility for an employer-sponsored retirement plan.
IRAs offer two distinct advantages in terms of taxes: potential deductibility of contributions and tax deferral on investment earnings.
Rules on Contribution Limits
In 2012, the maximum annual contribution is $5,000 (in general, married couples filing jointly can contribute a total of $10,000, even if only one spouse has income). Thereafter, the contribution limit will be adjusted for inflation. Individuals aged 50 and older are now able to take advantage of "catch up" contributions to IRAs. The allowable catch-up contribution is $1,000 per year. Maximum contributions may not exceed earned income.
In addition, you can open an IRA or make contributions to an existing IRA as late as the deadline for filing a tax return for that year. That means you would have until April 2013, to make your 2012 IRA contribution.
Tax Treatment of IRAs
Contributions to a traditional IRA may or may not be deductible from your earned income in a given tax year depending on your situation. Income limits apply if either you or your spouse participate in an employer-sponsored retirement savings plan. Deductibility is phased out over certain ranges of income as follows:
Traditional IRA Deductibility Phaseout Ranges for 2012*
$ in Thousands
Those covered by an employer-sponsored retirement plan
Those not covered by an employer-sponsored retirement plan, but filing a joint return with a spouse who is covered
*Based on modified adjusted gross income (MAGI).
The Magic of Tax-Deferred Compounding
The ability to make tax-deductible contributions to a traditional IRA can help your current tax situation. But you may want to invest in an IRA whether or not your contributions are deductible. Why? The real advantage of investing in an IRA is tax-deferred compounding of your investment earnings over the long term.
For example, if you had contributed $100 every month for 30 years to a tax-deferred IRA, then paid 25% tax on your withdrawals at retirement, you could have netted $112,522, assuming an 8% average annual rate of return. However, in an account that's taxed annually at a hypothetical rate of 25%, your total would have been only $100,954 - almost $12,000 less just because you had to pay taxes up front.1
Change Jobs, But Keep Your Retirement Money
IRAs can also come in handy when you're about to leave jobs and need to move your 401(k) money. If your former employer requires that you withdraw your retirement money, you can move your distribution safely from your former employer's qualified retirement plan into a rollover IRA and avoid owing current income tax on the distribution.
If you choose to physically receive part or all of your money and do not replace the entire amount within 60 days, you will be subject to penalty fees and taxes on the amount kept.
Withdrawing From Your IRA
Generally, any distribution you receive from an IRA before the day you reach age 59 1/2 is subject to a 10% additional tax imposed by the IRS, in addition to federal and state income tax. Beginning at age 59 1/2, you can withdraw money (of which any deductible contributions and investment earnings are taxable at your then-current income tax rate) from your IRA as desired without penalty, whether or not you are still employed.
But, as with any rule, there are exceptions. Distributions before age 59 1/2 are not subject to the penalty tax under certain circumstances, including when:
- You become permanently disabled.
- You die before age 59 1/2 and distributions are made to your beneficiary or estate after your death.
- You make withdrawals to pay deductible medical expenses that exceed 7.5% of your adjusted gross income.
- You make withdrawals for a qualified first-time home purchase (lifetime limit of $10,000).
- You make withdrawals to pay qualified higher education expenses for yourself, a spouse, children, or grandchildren.
By April 1 following the year in which you reach age 70 1/2, you must begin withdrawals from your IRA. A great advantage of taking only the required minimum distribution amount is that the balance continues to compound tax deferred. However, if your distributions in any year after you reach age 70 1/2 are less than the required minimum, you will be subject to a penalty tax equal to 50% of the difference.
Points to Remember
- If you have earned income or alimony, you can establish as many IRA accounts as you want prior to the tax year in which you reach age 70 1/2. Keep in mind, however, that you may be incurring annual account fees for each account, so maintaining multiple accounts may not be a prudent decision.
- Contribution limits are $5,000 or 100% of your earned income, whichever is less. Special "catch up" contributions of $1,000 are also available to individuals who are at least 50 years old.
- You can open an IRA or make contributions to an existing IRA as late as the tax-filing deadline for that year.
- Income limits restricting the deductibility of contributions apply if either you or your spouse participate in an employer-sponsored retirement savings plan.
- A major advantage of investing in an IRA is tax-deferred compounding.
- By April 1 following the year in which you reach age 70 1/2, you must begin withdrawals from your IRA.
- Individuals under the age of 59 1/2 can make withdrawals without a 10% additional tax to pay college expenses for themselves, a spouse, children, or grandchildren.
Take the Next Step with Merrill Edge
Click here to learn more about Traditional IRAs.
Self-directed investors can Open a Merrill Edge Traditional IRA account online. Need professional advice and guidance? Call the Merrill Edge Advisory Center at 1.888.MER.EDGE to open an account.