I am sure that you have heard of IRA and 401k retirement savings, but do you fully understand the meaning of these?
What is an IRA – Individual Retirement Account
IRAs are a way to save for retirement. An individual or their spouse, if filing a Joint tax return, must have earned income to contribute to an IRA. Investing in IRA’s means that you are establishing a tax-advantaged investment account that helps you save for retirement. This account will allow your money to grow and compound tax free, until it is withdrawn.
What is a Traditional IRA?
Traditional IRAs are tax-advantaged; what does that mean? Contributions to a traditional IRA qualifies for either a full deduction or partial deduction from Gross Income for that year, thereby resulting in tax savings. What this means is – instead of paying taxes on that income in the year earned, where one could be potentially in a higher tax bracket, that money grows tax-free. The individual will only pay taxes upon withdrawal, in a year where income could be lower, and the individual could be in a lower tax bracket.
What is a Roth IRA?
Like traditional IRAs, Roth IRAs serve the same purpose, it is essentially a retirement savings account. Where this differs is, contributions to Roth IRAs are from after-tax dollars. Contributions grow tax-free and the earnings will be tax-free and penalty-free, if you meet the holding period requirements. Under current tax law, if all the requirements are met, the entire amount of withdrawal from your Roth IRA could potentially be non-taxable.
Key distinctions of the above two types:
Both types have their advantages and disadvantages. Contribution to traditional IRAs could reduce taxable income. And the individual needs to begin taking distributions by April 1st following the year in which they turn 72 (and age 70 ½ if they reach that age before January 1, 2020). Any deductible contributions and earnings are taxable in the year of withdrawal.
Contribution to Roth IRAs comes from after-tax dollars as mentioned above. With Roth IRAs you can begin taking a distribution provided it has been at least 5 years since your first contribution or at age 59 ½, and the withdrawal is tax-free if it is a qualified distribution from the plan.
What is a 401k?
Like IRA’s, the 401k plan is also a retirement savings plan. The 401k plan, however, is only available through an employer. With a 401k plan, employees can make pre-tax contributions from their paychecks, subject to limits. Employees can contribute more to this plan than IRAs. And depending on how the employer’s plan is structured, employees may get a dollar-for-dollar match from their employer, up to a certain percentage of their deferrals. There are a variety of features that can be added to the 401(k) plan to make it customizable such as adding a Roth 401k feature making it similar to the Roth IRA.
If you have questions regarding IRAs or 401ks, The Innovative CPA Group is readily available to assist. Please get in touch with us at 203-489-0612 or via our contact form.