If you have not started on your retirement plan, it isn’t too late to start. The misconception that you can rely solely on your Social Security benefits when you get ready to retire could leave you with insufficient financial resources and a less than comfortable retirement. You need to have a plan in place that you can trust will meet your future needs. Retirement planning can take many shapes. Individual Retirement Accounts are one great way to start your plan.
How an Individual Retirement Plan works
An IRA, or individual retirement account, is really an investment account with several tax benefits. An IRA can offer a reliable way to save money for your retirement. With individual IRAs, you are not required to pay taxes on any earnings from the retirement account. Instead, those earnings can be reinvested so that your account is allowed to grow exponentially. Once you reach retirement age and start to make withdrawals, your tax obligation will depend entirely on the type of IRA you own, your current income and the amount of your withdrawals.
Understanding the various types of IRAs
There are basically four types of IRAs and each one has its own requirements and benefits. Traditional and Roth IRAs are accounts opened by individuals. There are also employer-sponsored IRAs known as Simplified Employee Pensions (SEPs) and Savings Incentive Match Plan for Employees (SIMPLE). Notwithstanding which form of IRA you choose to open, all IRAs are “fully vested.” In other words, all of your contributions and earnings belong to you. With employer-sponsored IRAs, this includes the contributions made by your employer.
Different types of IRAs have different limitations on contributions
The Internal Revenue Services establishes limitations on the total amount of annual contributions you can make to an IRA account and those limitations are subject to change every year. Therefore, it is wise to consult with your Kentucky retirement planning attorney regularly to be sure that you are complying with the current limitations each year. In 2016, for example, the maximum contribution for both Roth and Traditional IRAs is $5,500 if you are an individual under the age of 50. For people over age 50, the limit is $6,500. The maximum for a SIMPLE IRA is $12,500 if you are under age 50 and $15,500 if you are older. Finally, the contribution limit for SEP IRA sis $53,000.
How Traditional IRAs work
A traditional IRA is funded with what is known as “pre-tax” dollars. Essentially, this means you do not pay any taxes on the contributions you make or the interest you earn until you start to take withdrawals during retirement. At that point in time, every withdrawal you make will be taxed as regular income. For instance, if you owe 20% tax on your income and you take a withdrawal of $10,000 during the tax year, you will owe $2,000 in federal and state income tax.
How Roth IRAs work
A Roth IRA, on the other hand, is funded with “after-tax” dollars. For that reason, Roth IRAs do not provide the same initial tax benefits when it comes to contributions. As an alternative, the earnings and withdrawals from Roth IRAs are generally tax free. A major benefit of a Roth IRA is that, not only are your earnings allowed to increase tax-free, but you are note required to take any withdrawals from your Roth IRA, even if you are over 70 1/2. Further, if an when you start making withdrawals, those withdrawals are tax free. Put simply, you can avoid taxes when you contribute to the traditional IRA, but you avoid taxes with the Roth IRA when you withdraw money at retirement.
Penalties imposed on IRAs for early withdrawals
Regardless of the type of IRA you own, an early withdrawal penalty will be imposed if you take distributions from the IRA account before you reach age 59½. The penalty for a traditional IRA is 10% in addition to the income tax you are already required to pay on distributions. The Roth IRA has the added requirement that you have owned your IRA for at least five years before you begin taking distributions. Otherwise, you will be charged a penalty. One benefit of a Roth IRA, however, is that you can withdraw your original contributions at any time without penalty because you have essentially paid income tax on those funds already.
If you have questions regarding a IRAs, or any other retirement planning matters, contact the experienced estate and retirement planning attorneys at the Gersh Law Offices, P.S.C. for a complementary consultation either online or by calling us at (502) 423-7023.