Oxford Dictionary

IRA [noun] — Irish Republican Army or Individual Retirement Account (your pick).

ELI5

There are many ways to prepare for retirement and a common way to do so is to create an IRA, or individual retirement account. There are a number of different types of IRA’s, but typically individuals will open up either a Traditional IRA or a Roth IRA. The benefit of putting money into an IRA is that an individual has earmarked this money for the future, and it is not meant to be touched until they leave the workforce (of course there are a few, convenient, exceptions).

The terminology can be confusing, but really it comes down to a handful of concepts – taxes and contribution limits. Primarily — when the money is deposited into the account, whether the money is entered pre- or post-taxation.

For a traditional IRA, income before taxes is deposited to the account, and the individual can declare a tax deduction on that amount of income. When the money is withdrawn from the account, it is taxed as regular income.

For a Roth IRA, income post-taxes is deposited into the account. The benefit of this is that the no taxes are paid when the individual decides to withdraw the money giving some extra financial flexibility during retirement.

 

Detailed Definition

As mentioned above, some key concepts that need to be understood are contribution limits, age restrictions, withdrawal penalties, and also a couple less common IRA account types for the average person. We’ll structure the rest of this in an interview form.

Contribution Limits

Roth: Your contribution limits are also dependent on salary. Most importantly, for a Roth IRA, single tax-filers can’t contribute if their AGI earn more than $135K, and married tax-filers can’t contribute if their AGI is more than $190K. These numbers will vary year to year, and are also calculated in a specific way. AGI is adjusted gross income which is total gross income minus some deduction.

Traditional: There are no salary-based restrictions for traditional IRA’s.

As of 2018, an individual’s contribution to traditional and Roth IRA cannot be more than $5,500. This limit increases to $6,500 if the individual is 50 years or older. There are no salary-based restrictions for traditional IRA’s.

Age Limits

Roth: An individual can deposit money, up to the contribution limit, regardless of age any given year.

Traditional: An individual can deposit money, up to the contribution limit, up till they reach 70.5 years of age. This coincides with the age that traditional IRA’s force RMD’s or required minimum distribution (RMD). Refer here to see how it is calculated. Why does this exist? The government doesn’t want you to accumulate money and have it sit pretty in account, it would rather that money go towards the economy.

Penalties

Roth: In most cases, if an individual withdraws prior to the age of 59.5, the withdrawal will be categorized as gross income and an extra 10% tax penalty will be added.

Traditional: Same as Roth.

Exceptions

The exceptions tend to apply to both Roth and Traditional IRAs. Hardship distributions an immediate, financial need is seen. Typical cases include medical costs, disability, tuition, costs related to employee’s residence, funeral costs. These are covered as part of the “Safe Harbor” regulations, please check this for further information. It is also critical that no more than the amount needed to deal with the financial hardship is withdrawn from the account – or penalty fees will accrue. Individuals will be taxed on their hardship distribution as income tax.

There are also another handful of helpful exceptions to IRA early withdrawals. These benefits are specific to IRAs.

  • Healthcare insurance premiums when unemployed pending certain conditions.
  • First-time homebuyers can withdraw up to $10,000 without being penalized pending certain conditions.