Introduction to American IRA
- What is American IRA
Individual Retirement Accounts (IRAs) are investment vehicles designed by the U.S. Congress to provide tax incentives to save for retirement. Assets in an IRA are typically managed by an account custodian and are invested as individuals based on goals and direct inputs.
There are many types of IRAs, including some that offer tax breaks in the same year the money is deposited, and others that allow money to be withdrawn tax-free at any time. The two main types of individual retirement accounts (IRAs) are traditional IRAs and Roth IRAs.
- Traditional IRAs
Traditional IRAs were originally created by Congress in 1974 under the Employee Retirement Income Security Act (ERISA). This legislation provides special tax treatment for money deposited into IRAs and sets standards and rules to protect people who invest in these plans and prevent misuse of funds. Traditional IRAs are best for those who believe they will have a lower tax rate in retirement and for those who do not have access to other retirement plans such as a 401(k) through their employer.:
Traditional IRAs include traditional retirement accounts where pre-tax funds can be contributed (deductible IRAs) and retirement accounts where pre-tax funds cannot be contributed (non-deductible IRAs).
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Traditional Deductible IRAs
The feature of this account is that contributions are made with pretax dollars and subsequent withdrawals are fully taxed. Additionally, the purpose of the special tax rules for IRAs is to provide incentive for individual retirement savings. Therefore, there is a 10% penalty for early withdrawal (generally, before age 59?. This 10% penalty is in addition to ordinary income tax and cannot be deducted when determining ordinary income tax.
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Traditional Nondeductible IRAs
The feature of this account is that contributions are made with after-tax dollars and subsequent withdrawals are taxed only to the extent of income earned on the contributions. These accounts are primarily aimed at people with very high incomes or adjusted gross income (AGI) above the minimum, who are prohibited from contributing to an IRA with pre-tax amounts but can still contribute to the IRA. This group of people will only be taxed on the income/gain portion of the IRA when they withdraw from an IRA that has no pre-tax contributions after retirement.
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- Roth IRAs
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Roth IRAs were created by the Taxpayer Relief Act of 1997. Individuals can withdraw money from their Roth accounts at any time, in many cases incurring no fees and paying no taxes. Roth IRA is best for people who expect a higher tax rate in retirement. So, Roth IRAs can also serve as an emergency fund for many people.
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Roth IRAs income tax-free and penalty-free withdrawal prerequisites:
(a) The Roth IRAs has been in existence for at least five years.
(b) The payer must be at least 59 and a half years old to stop making contributions.
(c) Payers use the money to cover up to $10,000 for the first home purchase.
(d) Death or disability of the contributor
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- The Comparison of Traditional IRAs and Roth IRAs
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Similarities
(a) Contributions must be made at the same time of year.
(b) Contributions to Roth IRAs are limited to the lesser of an annual maximum indexed for inflation ($6,000 for 2022 with an additional catch-up contribution for taxpayers age 50+ of $1,000), and taxpayer’s taxable compensation for the year.
(c) As with traditional IRAs, Roth IRA contributions made in past years are allowed to remain in the IRA regardless of the level of modified AGI in future years
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Differences:
(a) No Required Minimum Distributions (RMDs) are required from Roth IRAs (except inherited Roth IRAs). But traditional deductible IRAs require taxpayers to make minimum withdrawals after age 72.
(b) In contrast to traditional deductible IRAs, Roth IRAs are after-tax funds and withdrawals are tax-free.
(c) Traditional deductible IRAs allow for tax deductions on contributions, while Roth IRAs do not.
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