How does an IRA work? How is an IRA taxed when you file a tax return?
An IRA is a special retirement account that you put money into that receives favorable tax treatment by laws of Congress and enforcement by the IRS. Each year a taxpayer can elect to contribute money to thier IRA using “out of pocket” money, as opposed to a 401k contributions which must be funded through payroll deductions and use a plan picked by an employer. With an IRA, the taxpayer can pick from hundreds of brokers and other financial service providers who can run the accounts.
IRA Info and Taxation of IRA for Retirement Account
The annual contribution limit is $5,500 in 2013 and 2014. Do not go over this limit or penalties will be applied. The provider that runs the IRS will provide a report to the IRS detailing your activity for the year.
There are two main types of tax advantaged IRAs that you can open to save money for retirement.
- Traditional IRAs, will reduce your taxable income if you are under a certain income limits defined yearly by the IRS. Since you contribute to an IRA with money that has been taxed already, you claim a deduction at the end of the year if you qualify. After you get your refund for your traditional IRA contribution this money becomes “tax-deferred” – you will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your traditional IRA in the future.
- If you contribute to a Roth IRA, your contributions have already been taxed at your current marginal income tax rate. In exchange, earnings may be distributed tax free if the distribution meets certain age and eligibility requirements.
Which type of IRA do you choose? Several factors in picking an IRA:
- Income Limits – Qualifying high earners are usually better off contributing to a traditional IRA, as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth IRA, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.
- Estimates about future income tax rates – Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional IRA if they qualify for the deduction. Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth IRA. Those that believe income tax rates will rise across the board in the future usually favor Roth IRAs.
Most discount brokers have options that allow people to open up IRA accounts.