"What is up with the different types of IRA’s?"
I have been receiving quite a few questions lately about IRA’s. Maybe it’s because April 15 is around the corner and people are still deciding what they should do about their 2012 contribution. And, yes you can still contribute for 2012 up until April 15, 2013. I decided to field Jason H’s question since it seemed the most general. In fact, I plan on making this a two part answer and will discuss the traditional IRA in this post.
Instead of diving into the traditional IRA the way a textbook or the IRS might, I’m going to attempt to use an analogy that most of us can relate. If you have ever contributed to a 401(k) or 403(b) then you probably had deductions taken directly from your paycheck. These deductions were pretax deductions which reduced the amount of income you had to claim to the IRS come tax time. These deductions lowered the tax you paid and may have even lowered your tax bracket. This is very similar to how a traditional IRA works.
In a traditional IRA, instead of your contribution coming straight from your paycheck, you make a contribution with after tax money. When it comes tax time, you deduct your contribution from your income. This is the same effect as taking it from your paycheck as a pretax contribution. When you hear traditional IRA, think of it as the same as a 401(k) with regards to its tax benefits.
Another similarity between the traditional IRA and a 401(k) is the tax treatment when the money is withdrawn. Remember that in most situations, the money in a 401(k) or a traditional IRA has never been taxed. Therefore, when the money is taken out, the IRS says that it is now time to tax it as earned income. This means that it is treated as if you were employed and it was all coming from a paycheck.
The final similarity is that in a 401(k) or traditional IRA withdrawals need to begin when you reach 70.5. There are very specific rules surrounding how much is withdrawn and when this needs to occur, and I will spare you all the gory details. Just know that even if you don’t need to take the money out for living expenses, the IRS makes you take it and pay the taxes.
There are limits to how much can be contributed to a traditional IRA. In 2012, you can contribute a maximum of $5000 and for 2013, a maximum of $5500. If you are over 50 then you can also contribute an additional $1000 for 2012 and for 2013.
The last point I would like to make specifically deals with who can deduct for a traditional IRA contribution. This is important because though everyone can contribute to a traditional IRA, only certain individuals can deduct their contributions. If you (and your spouse if married) do not have access to a qualified retirement plan at work (401(k), 403(b), pension, profit sharing, etc.), then you can always deduct your contributions. If you (or your spouse) have access to a qualified retirement plan, then there are income limits that may prohibit you from deducting your contributions. As an unmarried individual, you can make a fully deductible contribution in 2013 as long as your modified AGI (adjusted gross income) is under $59,000 ($58,000 in 2012). As a married couple, each person can make a fully deductible contribution in 2013 as long as your modified AGI is under $95,000 ($92,000 in 2012). It is possible to make a partially deductible contribution if you fall into a certain income range, but will not post on those details to avoid getting into minutia.
If you are following this post, you might ask why someone would make a traditional IRA contribution if they cannot deduct their contribution. I completely agree with your logic and for most people that do not have a specific strategy for doing so, this probably is not the wisest idea. There are specific strategies that make sense to make the contributions even if they aren’t deductible. These strategies are probably beyond the scope of this post as well.
Please look for the next post about Roth IRA’s. I am a HUGE fan of Roth IRA’s and I think you will find out why in my next post. Thank you as always for reading and please don’t forget to submit your question to Ask Garrett.