If your employer offers a 401(k) and provides matching funds, congratulations! That’s free money. Of course, you will want to contribute enough to get maximum matching funds.
But what if your employer does not offer a 401(k) or if you’re in business for yourself?
Then you need to immediately open an IRA or Individual Retirement Account.
If you leave an employer where you had a 401(k), it’s important to roll the money over into an IRA and here’s a video that explains why,
However, it does not explain which would be best for you — a traditional or a Roth IRA. This article explains the differences between the two and provides detailed information about Roth IRAs as well as what you would need to do to open and contribute to one.
The tax advantages of a traditional IRA
Both these IRAs are very similar. In both cases, you contribute funds on a regular basis and invest the money.
The biggest difference is that each has different tax implications.
The money contributed to a traditional IRA is fully tax-deductible – assuming your employer doesn’t offer any type of qualified retirement plan. If it does offer a plan and you’re a single filer earning less than $56,000 annually you would still qualify for a full deduction. If you‘re married, participate in an employer-sponsored retirement plan and earn less than $89,000, you would also be eligible for the full income tax deduction.
The money you contribute to a traditional IRA will grow tax-deferred. When you retire, and begin withdrawing money it will be taxed but you should then be in a lower tax bracket.
What’s a Roth IRA?
The simplest explanation of a Roth IRA is that it’s a savings account for retirement where you make contributions in after-tax dollars. In other words, unlike a traditional IRA the money you contribute to a Roth is not tax-deductible. However, the money you withdraw when you retire is tax-exempt. The contributions you would make to this type of IRA are discretionary, meaning that you can choose when you want to fund a Roth IRA.
Any person who has taxable income or income from self-employment for the year can open a Roth IRA. However, you must have a modified gross income that is less than a certain amount in order to make regular contributions to a Roth.
How much you can contribute to a Roth IRA will depend on your filing status. The maximum this year if you’re filing as single, head of household or married but filing separately is $132,000.
If you’re married and filing a joint return the maximum you can contribute is $194,000.
How compensation is defined
If you’re working for an employer then compensation you could contribute to a Roth IRA includes wages, commissions, salaries, bonuses and any other amount of money that is paid to you for the work you perform for your employer. If you’re a self-employed person or a partner in a partnership, then compensation is defined as all of your net earnings minus any deductions you’re allowed for the contributions you make to your retirement plans.
Compensation that’s ineligible
Unfortunately, there are some types of compensation that are not eligible for contribution to a Roth IRA. This includes rental income or other money you earned as the result of property maintenance as well as interest and dividends. Plus, you would not be allowed to contribute any amount of money you would exclude from your taxable income.
How to fund a Roth IRA
It’s possible to fund a Roth IRA from several sources. In addition to regular contributions this could be contributions from your spouse, rollover contributions, transfers and conversions.
According to the Investopedia website you are allowed to establish and contribute to a Roth IRA for a spouse that makes very little or no income. Again, according to Investopedia, contributions to a spousal Roth IRA are subject to the same regulations and rules as your normal Roth IRA contributions. However, a Roth IRA you create for your spouse must be kept separate from your Roth IRA. In other words, the two can’t be held in a joint account.
There are several requirements for you to make contributions to a spousal Roth IRA.
Investopedia reports that you would need to be married and filing jointly. You must have compensation that is eligible and the total contributions for you and your spouse must not be more than the taxable income you report on your joint tax return.
Transfers are defined as a movement of money between comparable types of retirement plans. Transfers are nontaxable and non-reportable. If you own several Roth IRAs, you might be transferring assets between two of them to consolidate money or because you’re moving from one financial institution to another.
You can also transfer IRA money from a spouse’s Roth IRA to another IRA. You can transfer money between Roth IRAs as often as you wish.
You are legally allowed to make a rollover contribution to you or your spouse’s Roth IRA. It’s tax-free, However, it’s different from a transfer in that you must report it to the IRS and to the owner of the Roth IRA on form 1099-R. You must also report it on IRS form 5498. You can only rollover one distribution from a Roth IRA a year. The contribution can come from a distribution from another Roth IRA or the same Roth IRA.
Investopedia defines conversions as a movement of money from a SIMPLE IRA, a traditional IRA or a SEP to a Roth IRA. Conversions, too, must be reported. You are not allowed to convert SIMPLE IRA assets to a Roth until two years after your employer first makes a contribution to your SIMPLE IRA. You must report conversations to both the owner of the IRA and the IRS on form 1099-R (for a traditional IRA) and IRS form 5498 for the Roth IRA. You can make an unlimited number of conversions within any single year. And for eligibility purposes there is no income limit on conversions.