Interestingly, there are 11 different types of IRAs ranging from Individual Retirement Accounts, Employer and Employee Association Trust Account, Spousal IRAs, Rollover Conduit IRA, etc. The most common are the traditional IRAs and the Roth IRA. In this article, we will explain the differences & similarities between the two.
In Traditional IRA, the contributions you make towards the account are not taxed. Whatever capital gains & earnings you make on your IRA are also not taxed up until retirement, when you withdraw money from your account. For example, imagine you made $50,000 this year and contributed $5000 to a traditional IRA. You will be taxed on $50,000 – $5000 = $45,000. Furthermore, your $5000 contribution will grow tax-deferred for many years, until you retire and decide to withdraw it. The setback with this is that your $5000 (which would have probably grown to $50,000 upon retirement) will then be taxed at your ordinary income tax rate.
Note: You can only withdraw this money after you turn 59 and 1/2 years or older. Any withdrawals made before this age will be subject to income taxes as well as a 10% early withdrawal penalty. However if you use the withdrawn funds to finance higher education expenses or for the below list of 8 exceptions, you will not have to pay the 10% early withdrawal penalty.
8 Exceptions that Eliminate the 10% Early Withdrawal Penalty
There are 8 exceptions to the 10% early withdrawal penalty (i.e. withdrawals that are taken before the age of 59 and 1/2). They are for distributions that:
i) Are taken because of the IRA owner’s disability
ii) Are taken because of the IRA owner’s death
iii) Are a series of loan repayments made over the life expectancy of the IRA investor
iv) Are used to pay for unreimbursed medical expenses that exceed 7.5% of the adjusted gross income of the IRA owner
v) Are used to pay for medical insurance premiums if the IRA investor has been unemployed for more than 12 weeks
vi) Are used to pay for the purchase of a principal residence (maximum of $10,000 can be withdrawn). Also, the IRA investor must not have previously owned a home within the last 24 months.
vii) Are used to pay for higher education expenses of the IRA owner or eligible dependants/family
viii) Are used to pay back taxes of an IRS levy placed against the IRA
Traditional IRAs are commonly associated with the old way of investing: certificates of deposits. This stereotype is because most banks sell CDs and they are the ones that offer Traditional IRA accounts for investors. But remember, you are not limited to investing Certificates of Deposit or bonds only, you can make higher risk investments such as cyclical stocks, commodities, futures, ETFs, etc.