An individual retirement account can give you tax benefits. You won’t pay taxes on the money inside a traditional IRA until you withdraw it, and you get a tax deduction for the money you contribute. You don’t get a tax deduction from a Roth IRA, but you can take out your money tax-free if you follow the rules. You “convert” a taxable account to an IRA through contributions, but the Internal Revenue Service imposes limits.
Contributions to a Traditional IRA
In 2013, you can contribute the lesser of your gross income and $5,500 to a traditional IRA, but if you’re age 50 or older, the limit is $6,500. You can only contribute cash, not property. This means you cannot transfer stocks, bonds, mutual fund shares or any other investment from your taxable account. The IRS places no income limits on contributions to traditional IRAs, but it may slash your deduction if you or your spouse take part in a qualified retirement plan at work and your income exceeds an annual limit. The IRS updates this limit yearly. For maximum flexibility, consider opening a self-directed IRA -- this allows you to purchase a wide range of investments.
Contributions to a Roth IRA
Roth and traditional IRAs share the same contribution limits. However, the IRS places an income limitation on Roth contributions. The limit is a range of modified adjusted gross incomes: The lower threshold indicates when the IRS begins to scale back the amount you can sock away. You can’t contribute any money to a Roth IRA if your MAGI exceeds the range’s upper limit. In 2013, the MAGI range for married couples filing jointly is $178,000 to $188,000. The range for individuals is $112,000 to $127,000.
If you plan to sell securities at a loss in your taxable account, contribute the proceeds to an IRA and then repurchase the shares, beware of the wash sale rules, which apply when you repurchase within 30 days of a loss. Normally, the wash sale rules delay your tax deduction on a capital loss. Instead of immediately deducting the loss, you add the disallowed deduction to the cost basis -- the purchase price plus commissions -- of the replacement shares. You benefit from the higher basis when you eventually sell the replacement shares, because it cuts your profit or widens your loss. However, if you buy the replacement shares in an IRA, you permanently lose the tax deduction, because you don’t deduct losses in an IRA.
If you are planning to move some of your investing activity to an IRA, you’ll have to decide whether to open a traditional or a Roth account. One factor is the choice between immediate tax deductions versus tax-free withdrawals in retirement. To help decide, consider your income and work expectations after you reach 59 1/2. If you plan to stop working early and live on a fixed income, you'll probably be in a lower tax bracket than your current one. Tax-free withdrawals from a Roth IRA are less valuable if your tax rate is low. On the other hand, if you plan to work into your 70s, you might prefer a Roth account, because unlike a traditional IRA, it doesn’t force you to take required minimum distributions after age 70 1/2.
- Internal Revenue Service: Retirement Topics - IRA Contribution Limits
- Internal Revenue Service: IRA Deduction Limits
- Internal Revenue Service: Amount of Roth IRA Contributions That You Can Make For 2013
- Internal Revenue Service Publication 550: Investment Income and Expenses
- Internal Revenue Service: Traditional and Roth IRAs
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- How to Transfer IRA Money to Another Institution Without Paying Taxes
- Are Distributions From a Roth IRA Taxable?
- How Much Must One Earn to Contribute to a Roth IRA?
- Can I Convert My After-Tax Contributions to a Roth IRA?
- When Are Early Distributions From an IRA Not Taxable?
- Can a Roth Conversion Be Moved in Kind?
- Roth Vs. Traditional Vs. Rollover IRA
- Taxable Accounts vs. Non-Deductible IRA