Question

Briefly describe how the traditional individual retirement accounts (IRA) and Roth retirement accounts work. Make sure you mention the nature of tax deductibility associated with these two types of retirement accounts.

Answer 1

Traditional individual retirement accounts :

These are the accounts which are tax deductible. That is if you invest any amount of money in these accounts they are deductible from Gross Taxable Income.

For example let your gross taxable income is $4000

if you save $1000 in Traditional individual retirement accounts then this amount is deductible from gross taxable income. that is your effective gross taxable income = $4000 - $ 1000 = $3000. So you need not pay tax on $1000.

If the gains from this $1000 is $100 . Then this $100 is taxable.

Though the principal amount is tax deductible the earnings (like interest) are taxable when you withdraw the money.

Advantages:

Amount invested is tax deductible.

You can defer the tax on the earnings from this accounts. That is you need not include these earnings in your annual tax returns. You can pay the tax when you close the account. Generally the account will be closed after retirement, you will be in lower tax brackets and you will pay less tax.

Disadvantages:

Earnings from the account are taxable.

These accounts will have lock in period and if you close prematurely you need to pay both the tax and penalty.

Roth Retirement Accounts:

These are exactly opposite of the Traditional individual retirement accounts.

The investment in these accounts is not tax deductible but the earnings or distributions from these accounts are exempted from tax.

Advantages:

Distributions are exempted from tax

Growth from savings is exempted from tax.

Even if you covered by retirement plan you can still subscribe to Roth accounts.

Disadvantages:

Contributions (Principal Amount) is not exempted from tax

These accounts have some income limitations