Individual retirement accounts, or IRAs, are Internal Revenue Service-approved accounts, in which you can tuck away money for your golden years. The two major types of IRAs are traditional and Roth, and each has its own rules for the tax treatment of contributions and withdrawals. Both plans offer tax advantages that can help you boost your retirement savings.
Contributions to a traditional IRA are deductible from your income right up to the tax return filing deadline. For example, you could make a contribution on April 12 and still deduct it for the prior year. The contribution lowers the total amount of tax that you have to pay. Report all of your contributions to a traditional IRA on Line 32 of your 1040 return. Uncle Sam provides a worksheet to help you calculate your contributions eligible for deduction. Annual contributions are limited to the lesser of $5,000 or 100 percent of your income for 2012 ($5,500 in 2013). If you are 50 or older, the limit is $6,000 in 2012 ($6,500 in 2013). If either you or your spouse is covered by an employer-sponsored retirement plan, such as a 401(k), your allowable deduction starts to decline at higher income levels. Contributions to a Roth IRA have the same limits, but the contributions are not deductible from your taxes, and you don't report them on your return.
If you buy and sell stock, it creates capital gains. Bonds generate interest income, and some stocks pay dividends. These are the three main types of investment income that you can earn in any portfolio. If you earn it outside of your IRS-approved retirement accounts, you must include it for tax purposes in the year it was earned. The good news is that, inside your traditional and Roth IRAs, the income can grow without claiming taxable income. In a traditional IRA, the income will only get taxed when it is withdrawn from the plan, and then it is treated as ordinary income. In a Roth IRA, the income is never taxed.
IRAs are meant to provide you with income in retirement, and Uncle Sam wants to keep it that way. If you take money out of your traditional IRA before you turn 59-1/2 years old, the IRS will tax you on it and also charge a 10 percent penalty on the entire withdrawal. You can withdraw your contributions from your Roth IRA whenever you like -- remember, you didn't get a tax break in the first place -- but if you take out any of the accumulated income early, you'll get dinged with the penalty on top of paying tax on it.
Once you turn 59-1/2, you can take as much money as you like out of either your traditional or Roth IRA without penalty. All of the withdrawals from your traditional IRA are taxable on your return. None of your Roth IRA withdrawals are taxable at all. You can make direct withdrawals from the plans or convert them to an annuity that pays you a steady income. The plan administrator will send you IRS Form 1099-R for all withdrawals and distributions from retirement plans and annuities.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.