Emancipation Day, a holiday observed in the District of Columbia, falls on Friday, April 15 this year. Therefore, the tax reporting deadline has been pushed back to Monday, April 18. This means the deadline to contribute to a Traditional IRA, Roth IRA, and SEP IRA for the 2010 tax year corresponds to this same date.
What is a Traditional IRA?
A Traditional Individual Retirement Account (IRA) is an account primarily used to save money on a pre-tax basis. This means contributions placed into a Traditional IRA can be deducted from your taxable income. Therefore, reducing the amount of taxes you have to pay. In addition, the accumulation in an IRA grows tax-deferred. Dividends and interest are not taxed when the gains are realized. Instead, they are deferred until a withdrawal is taken from the Traditional IRA. Anyone can open and contribute to a Traditional IRA. However, there are restrictions regarding the eligibility to deduct contributions. Please consult with your tax professional or investment advisor to determine your eligibility.
Of course, the IRS is not going to allow too much of a good thing when it comes to tax reduction. Current contribution limits for both 2010 and 2011 are up to $5,000 for individuals with a “catch-up” provision that allows investors age 50 and over to contribute up to $6,000. Taxpayers earning under the contribution limits can only contribute up to their income. With certain exceptions (college costs and first-time home purchase among the most common), there is a 10% tax penalty for withdrawals taken prior to age 59.5.
What is a Roth IRA?
Unlike a Traditional IRA, a Roth IRA does not provide a tax deduction when a contribution is made. Similar to a Traditional IRA, the investments in a Roth IRA grow tax-deferred. The advantage of a Roth IRA comes when withdrawals are taken in retirement. Assuming an investor has established a Roth IRA for at least five years and is over the age 59.5, distributions come out tax-free. The Roth IRA also allows for certain exceptions to the early withdrawal penalty, such as college costs and first-time home purchase costs up to $10,000, prior to age 59.5. It should be noted that the Roth IRA also allows for the investor to take out contributions (not growth) at any time without penalty or tax consequence. The same contribution limits apply as the Traditional IRA and there are income eligibility limits to contribute to a Roth IRA. Once again, your tax professional or investment advisor should be consulted to determine your eligibility.
What is a SEP IRA?
A SEP IRA is a retirement account designed to benefit self-employed individuals. It can work with many forms of businesses, but often works best for a business owner without employees. It is very similar to a Traditional IRA from the standpoint of contributions being tax-deductible, accumulations growing tax-deferred, and the tax penalty for taking a withdrawal prior to age 59.5. The main advantage to the business owner is the high contribution limits. In general, a business owner can contribute up to 25% of qualified income to a maximum of $49,000 for the tax years 2010 and 2011. Contributions can be made for the prior year up to the tax deadline (or extended deadline). Again, please consult your tax professional to provide you with your SEP IRA contribution limit.
IRAs in all the forms mentioned above can be an important part of your financial plan. Investors should asses how these instruments fit into your tax and investment situation. In the correct circumstance, IRAs can provide a tax-advantaged way to save money in taxes while saving for financial goals.