In the United States, individuals earning a gainful income by means of employment can make investments (contributions) into an Individual Retirement Account (IRA). There are several different methods by which the individual can make contributions to an IRA: the traditional 401(k) Plan, the Self-Employed Plan (SEP), the Savings Incentive Match Plan for Employees (SIMPLE), and the Roth IRA Application are to name a few. One factor that differentiates these retirement plans is the way in which taxes are applied to the IRA funds.
Each of these plans will allow for different contribution values depending on the individual’s income and tax filing status (single, married, head of household, etc.). When using the 401(k), SEP, or SIMPLE plan, the contributions are made to the IRA from the individual’s gross income. In doing so, the individuals adjusted gross income (AGI) will be lowered by these contributions, resulting in a lower tax liability for the income.
Once an individual has reached the age of retirement, withdrawals (distributions) of funds can be made from the IRA account. When funds from the IRA are distributed, the tax liability is then due. The Roth IRA Application (named for Senator William V. Roth Jr. of Delaware [1921-2003]) uses a slightly different taxing strategy.
In accordance with the Taxpayer Relief Act of 1997, when an individual makes a contribution to a Roth, the contribution comes from the individual’s net income; therefore, the money from the Roth IRA contribution limits have already been taxed. Because this money has already been taxed, any distribution from a Roth IRA is done so tax-free. A Roth IRA can be set up as an investment account containing securities such as common stocks bonds handled through a mutual fund or it can be handled as an annuity or endowment contract purchased through a life insurance company.
As with any financial venture, it is advised to seek professional consultation to discover any unforeseen ramifications of your actions — this would include making a decision as to which IRA best suits your needs.
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