Tax Research Paper free essay sample

A lot of people mistakenly think an IRA itself is an investment but it is just the basket in which an individual keeps stocks, bonds, mutual funds and other assets. Unlike 401(k)s, which are accounts provided by employees’ company, the most common types of IRAs are accounts that people open on their own. Others can be opened by self-employed individuals and small business owners. There are two general types of individual retirement arrangements (IRAs) under present law: * traditional IRAs, to which both deductible and nondeductible contributions may be made; * Roth IRAs, to which only nondeductible contributions may be made. So understanding each account and their differences helps an individual determine which IRA is best for his financial situation and retirement plans. Traditional IRA Basics A traditional IRA is a personal retirement savings account held at a bank or a brokerage firm that can be funded with investments such as stocks, bonds and mutual funds offered through the financial institution where individual account is held. Traditional IRAs provide tax savings, including tax-free growth of earned interest, dividends and capital gains while the money is in the account. An individual also usually claims a tax deduction each year that he makes a contribution to a traditional IRA. While his contributions to a traditional IRA are not taxed, he has to pay taxed when he remove the funds from the account at retirement. Roth IRA Basics A Roth IRA is a personal retirement savings account also held at a bank or brokerage firm that can be funded with a wide variety of investments, including stocks, bonds and mutual funds. Roth IRAs also offer tax savings, including tax-free growth of earned interest, dividends and capital gains while the money is in the account, but An individual is not taxed when he withdraws the money. Withdrawals of contributions are tax free after the Roth IRA has been open five years, and individual can withdraw investment earnings tax free after he reaches the age of 591/2. Traditional IRAs vs. Roth IRAs When it comes investments, traditional and Roth IRAs work the same way. An individual funds the IRA and then moves the money into various investments. With both types of accounts, the interest, dividends and capital gains grow tax free. If an individual is employed and earning an income, he can currently contribute to both types of accounts up to $5,000 per year until the age of 49 and $6,000 per year if he is 50 or older. Contributions to either type of IRA must come from taxable income earned from working. Earned income also includes alimony received by the taxpayer. For federal income tax purposes, alimony is deductible by the payor and is includible as earned income by the recipient. The following table provides the similarities of traditional IRA vs. Roth IRAs. | Traditional IRA| Roth IRA| Earned Income| v| v| Investment Choices| v| v| Prohibited Transactions| v| v| However, there are several important differences between traditional and Roth IRAs. Consider the following differences when making a decision regarding which type of IRA is right for your financial situation. Tax Deferral Traditional IRA: Contributions are taxed at the prevailing tax rate when money is taken from the account at retirement. Individual contributions are not taxed when he initially deposits them into his account. Roth IRA: Because individual contributions are taxed before they land in his account, his money is not taxed when it is removed from the account. Age Limits Traditional IRA: No contributions are allowed in the year or any years after the year in which an individual attains age 701/2. Roth IRA: No age limits exist on contributions. Individuals who have sufficient earned income may continue to contribute to a Roth IRA after the attainment of age 701/2. Income Caps Traditional IRA: Anyone with a taxable income can contribute to a traditional IRA, no matter how much they earn. Roth IRA: There are income limits for contributing. In 2012, single individuals with a modified adjusted gross income of $125,000 and higher could not contribute to a Roth IRA. Tax Deductibility Traditional IRA: Contributions may be tax deductible. Eligibility is dependent on a variety of factors including whether an individual is currently participating in an employer – sponsored retirement plan such as a 401 (k), SEP IRA or SIMPLE IRA. Enrollment in one of these plans can limit or preclude tax deductibility. Income also dictates if and how much a person can deduct. In 2012, for instance, an individual filing single or as head of household with no active participation in an employer – sponsored retirement plan who earned $58,000 or less in modified adjusted gross income could fully deduct all contributions to a traditional IRA. Individuals earning from $58,000 to $68,000 got a partial deduction, and those earning more than $68,000 had no deduction. Roth IRA: No contributions are tax deductible. Required Minimum Distribution (RMD) Traditional IRA: Account owners must begin receiving minimum distributions of money in the account on April 1st of the year following their turning 701/2 years old. Roth IRA: No required minimum distribution. Distributions Traditional IRA: Distributions from traditional IRAs and other retirement plans are generally treated as ordinary income. Roth IRA: Distributions from Roth IRAs are designed to be tax-free in retirement. A distribution from a Roth IRA is not included in the owner’s gross income and is not subject to the 10 percent early withdrawal penalty if it is a qualified distribution. Distributions that do not meet the definition of a qualified distribution may be subject to income tax and the early withdrawal penalty. Early Disbursement Traditional IRA: If an individual pulls money out of the account before the age of 591/2, he will be subject to an early distribution penalty. Exceptions to the early disbursement penalty rule include withdrawing money in order to pay for college expenses, medical costs greater the 7. 5% of your adjusted gross income and expensed due to sudden disability. He can also withdraw up to $10,000 penalty free for a first-time home purchase. Finally, there are no penalties if he transfers the money into another type of retirement account. Roth IRA: After the account has been open five years, an individual can withdraw any money he deposited into the account without incurring a penalty. He will, however, usually pay a penalty if he withdraws investment earnings before the age of 591/2. Through the discussion above, the table below provides the differences of traditional IRA vs. Roth IRAs, | Traditional IRA| Roth IRA| Contributions| Contributions can not be made beyond 701/2| Contributions can be made beyond 701/2| Deductions| v| N/A| Minimum Distribution Rules| During life and after Death| Only after death| Conclusions Upon the discussion above, we can decide which account is best for a specific person. If a person does not meet the income requirements for a Roth IRA, a traditional IRA is his only choice. Otherwise, he needs to take a few factors into consideration when making his decision. If a person wants to take advantage of the tax deductibility of his IRA contributions, he might consider choosing a traditional IRA. Opting for a traditional IRA also makes sense if he expects to be in a lower tax bracket when he retires, because he will pay less tax at that time than he would now. However, the flexible benefits of a Roth IRA may make it a more appealing choice. A person might benefit from his ability to withdraw contributions without penalties. He might also prefer to have no minimum distribution requirements. Finally, if he expects to be in a higher tax bracket when he retires, choosing a Roth ill allow him to get his contributions taxed at a lower rate now, and he will not have to worry about taxes later. Splitting a Person’s Contributions If a person is eligible for a Roth and Traditional IRA, he may find it advantageous to split his maximum contribution between the two by depositing the tax deductible amount of his income into his traditional IRA and the remainder into a Roth. When considering doing this, factor in potential additional costs such as fees associated with funding both accounts. His total contributions to both IRAs can not be more than his limit for the year.