An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you’re contributing to a 401(k) or other plan at work, you might also consider investing in an IRA.
What types of IRAs are available?
The two major types of IRAs are traditional IRAs and Roth IRAs. Both allow you to contribute as much as $5,500 in 2018 (unchanged from 2017). You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she has little or no taxable compensation, as long as your combined compensation is at least equal to your total contributions. The law also allows taxpayers age 50 and older to make additional “catch-up” contributions. These folks can contribute up to $6,500 in 2018 (unchanged from 2017).
Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that’s best for you.
Note: Special rules apply to certain reservists and national guardsmen called to active duty after September 11, 2001.
Learn the rules for Roth IRAs
Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation in 2018 is at least $5,500, you may be able to contribute the full amount. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status:
- If your filing status is single or head of household, and your MAGI for 2018 is $120,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $120,000 and less than $135,000, and you can’t contribute to a Roth IRA at all if your MAGI is $135,000 or more.
- If your filing status is married filing jointly or qualifying widow(er), and your MAGI for 2018 is $189,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $189,000 and less than $199,000, and you can’t contribute to a Roth IRA at all if your MAGI is $199,000 or more.
- If your filing status is married filing separately, your Roth IRA contribution is reduced if your MAGI is less than $10,000, and you can’t contribute to a Roth IRA at all if your MAGI is $10,000 or more.
Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that if you meet certain conditions, your withdrawals from a Roth IRA will be completely income tax free, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:
- You have reached age 59½ by the time of the withdrawal
- The withdrawal is made because of disability
- The withdrawal is made to pay first-time home-buyer expenses ($10,000 lifetime limit)
- The withdrawal is made by your beneficiary or estate after your death
Qualified distributions will also avoid the 10% early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even nonqualified distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made. You must aggregate all of your Roth IRAs — other than inherited Roth IRAs — when calculating the tax consequences of a distribution.
Another advantage of the Roth IRA is that there are no required distributions after age 70½ or at any time during your life. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution. Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70½.