Clearing the AIR on IRAs

IRAs come packed with many layers of rules around contributions, withdrawals, taxation, ownership, inheritance, and beneficiaries, so it's no surprise that I get so many questions about these accounts. To start the new year off right, let's take a look in a series of posts on the topic.

The Basics

The strategy is fairly straightforward if you really boil it down:

-Contribute to a traditional IRA (or traditional 401(K)) if your income now might be higher than you expect in retirement. You'll reduce today's taxes, but only defer them until retirement.

-Contribute to a Roth IRA or (or Roth 401(K)) if your retirement income might be higher than your income is now. You'll pay the tax now, and you could avoid ever again paying taxes on those contributions and the earnings.
(And, if you're lucky enough to know whether tax rates themselves will be higher or lower in the future, you can calculate that into your strategy as well.) 

In both cases, you'll get the benefit of having the earnings shielded from you until after age 59.5 by way of early withdrawal penalties. That's a bonus if you have trouble keeping your savings hidden from yourself.

In Retirement

The most common question is about how savings in an IRA gets taxed in retirement.

For traditional IRAs, required distributions begin after age 70.5. It's a once-a-year calculation that starts around 3.6% of the account value and creeps upwards a little each year. For example, an IRA with a balance of $100,000 at year-end will have a $3,649.64 required distribution in the year that the account holder turns 70.5. That withdrawal can be spent or reinvested in an after-tax account. The amount appears as income on your tax return for that tax year. (Side note: you can also optionally direct up to $100,000 of a required minimum distribution to charity and avoid the tax.)

For Roth IRAs, things are far more simple. No distributions out of the account are required (ever) during your life.

Next Up

Contribution limits and strategies.