Traditional IRA and Roth IRA

What is IRA?

An IRA is an INDIVIDUAL RETIREMENT ACCOUNT. An IRA is a personal savings plan that provides income tax advantages to individuals saving money for retirement purposes.

How does it work...?

You invest money in an IRA, up to the amounts allowable under the tax law. These investments are termed "contributions." In many instances an income tax deduction is available for the tax year for which the funds are contributed. The contributions, as well as the earnings and gains from these contributions, accumulate tax-free until you withdraw the money from the account. You therefore enjoy the ability to generate additional earnings, unreduced by taxes on these earnings, each year the funds remain within the IRA.

The withdrawals of the funds from the IRA are termed "distributions." Distributions are subject to income taxation, generally in the year in which you receive them. (Remember that in most cases you received an income tax deduction when you contributed the money to the IRA.) As with most things involving the government, the rules for distributions are more complicated than they need to be.

Since the original purpose of the IRA is to assist you in providing for your own retirement, there is a disincentive for withdrawing your IRA funds prior to an assumed retirement age of 59 1/2. This disincentive takes the form of a tax "penalty" in the amount of 10 % of the distributions received by you prior to age 59 1/2, unless certain exceptions apply. Given the complexity of this issue alone, professional advice should be obtained whenever significant amounts of distributions are needed prior to age 59 1/2. The fact is that many times the penalty can be avoided with proper planning. Obviously these distributions, whether before age 59 1/2 or later, are subject to income taxation upon receipt. Once you are age 59 1/2 this penalty, termed a "Premature Distribution" penalty, is no longer applicable.

On the flip side of the government not wanting you to withdraw your money at too young an age, it also has rules to prevent you from not withdrawing the money soon enough. (This is done in order that the government can tax it.) You usually need to begin taking money from your IRA no later than April 1 of the calendar year following the date you attained age 70 1/2. The rules established by the government regarding these Required Minimum Distributions, their timing, the amounts, the recalculations, and the effect various beneficiary designations have on them, are among the most complex of the Internal Revenue Code. The penalty is 50 % of the shortfall between what you should have withdrawn and the amounts you actually withdrew by the proper date. This punitive penalty is matched only by the civil fraud penalty in severity. The necessary calculations are therefore not something that most individuals should attempt on their own.

My observations:

IRA: is pretax. So it will reduce ur tax bracket by so much amount you are investing

IRA: If you withdraw after 59.5 yrs, you will hv to pay tax on both principle + interest you made

IRA: If you withdraw before hand, you have to pay 10% penality fee + taxes you owe (You can avoid the penality fee, if you take out for ur first home or higher education). at else, when you distribute (IRA tech term for withdrawl :D) the amount will add up to the total income you made.. and it might again increase your tax bracket for the year.


Roth IRA : is after tax: So you will have to pay taxes first and then invest.

Roth IRA : If you withdraw after 59.5 yrs, you will just hv to pay tax on the interest you made

Roth IRA : You can withdaw at anytime before 59.9 w/o 10 % penality and just pay taxes on the interest you owe.

Essentials of financial knowledge